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American depository receipt adr

What Is American Depository Receipt (ADR)?

An American Depository Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents a specified number of shares of a foreign company's stock. These certificates allow shares of non-U.S. companies to trade on U.S. stock exchanges or the over-the-counter (OTC) market, facilitating international investing by making foreign equity securities more accessible to American investors. ADRs are denominated in U.S. dollars and pay dividend payments in dollars, simplifying transactions and reporting for U.S. investors.

History and Origin

Before the advent of American Depository Receipts, U.S. investors seeking to own shares in non-U.S. companies faced significant hurdles, including navigating foreign stock markets, dealing with different regulatory environments, and managing currency exchange rates. To address these complexities, the concept of ADRs was introduced in the 1920s. J.P. Morgan issued the very first ADR in 1927 for the British retailer Selfridges. This innovative financial instrument aimed to provide American investors with a straightforward and secure avenue for investment in international companies. Since their inception, ADRs have evolved significantly, becoming a crucial component of global capital markets by bridging various national stock markets and enabling cross-border investment flows.19,18

Key Takeaways

  • An American Depository Receipt (ADR) is a certificate issued by a U.S. bank, representing shares of a foreign company, that trades on U.S. markets.
  • ADRs allow U.S. investors to gain exposure to foreign companies without directly trading on overseas exchanges.
  • They are denominated in U.S. dollars, simplifying pricing and dividend payments for American investors.
  • While offering accessibility, ADRs carry specific risks, including currency fluctuations and potential double taxation.
  • The U.S. Securities and Exchange Commission (SEC) regulates ADRs, with various levels of programs determining disclosure requirements.

Interpreting the American Depository Receipt

An American Depository Receipt (ADR) simplifies foreign investment by allowing U.S. investors to buy shares of non-U.S. companies domestically. Each ADR typically represents a specific number of underlying shares of the foreign company, which can be one-for-one, a fraction of a share, or multiple shares. This ratio is set to make the ADR's price per share more aligned with typical U.S. stock prices, making them more appealing and easier to trade for American investors.17

When interpreting an ADR, an investor considers the performance of the underlying foreign company and the currency exchange rates between the U.S. dollar and the foreign company's home currency. Even though an ADR trades in U.S. dollars, its value is directly impacted by changes in the foreign currency's value relative to the dollar. For example, if the foreign currency weakens against the U.S. dollar, the value of the ADR, when converted back to U.S. dollars, will decline even if the underlying stock price in its home market remains stable.16

Hypothetical Example

Imagine an American investor, Sarah, wants to invest in "Maple Leaf Corp.," a popular Canadian company. Instead of opening a Canadian brokerage account and dealing with Canadian dollars and regulations, Sarah can purchase Maple Leaf Corp. ADRs through her U.S. broker.

Suppose Maple Leaf Corp. trades on the Toronto Stock Exchange at CAD 200 per share. A U.S. depositary bank issues ADRs for Maple Leaf Corp. with a ratio of 1 ADR representing 4 shares of Maple Leaf Corp.'s common stock. If the exchange rate is USD 1 = CAD 1.30, then:

  1. Value of underlying shares per ADR: 4 shares * CAD 200/share = CAD 800
  2. Conversion to USD: CAD 800 / 1.30 = USD 615.38 (approx.)

So, the ADR would initially trade around USD 615.38. If Sarah buys 10 ADRs, her total investment is approximately $6,153.80.

A month later, Maple Leaf Corp.'s stock rises to CAD 210 per share, but the Canadian dollar weakens, and the exchange rate moves to USD 1 = CAD 1.35.

  1. New value of underlying shares per ADR: 4 shares * CAD 210/share = CAD 840
  2. New conversion to USD: CAD 840 / 1.35 = USD 622.22 (approx.)

Sarah's 10 ADRs are now worth approximately USD 6,222.20. Even though Maple Leaf Corp.'s stock price increased in its local currency, the weakening of the Canadian dollar mitigated some of the gains for Sarah, demonstrating the inherent currency risk in ADRs.

Practical Applications

American Depository Receipts (ADRs) are widely used in several areas of finance and investing:

  • International Diversification: ADRs offer a straightforward way for U.S. investors to add foreign equities to their portfolio, facilitating exposure to international markets without the complexities of direct foreign stock purchases.15
  • Access to Foreign Companies: Many prominent global companies that do not list their shares directly on U.S. exchanges make them available through ADR programs, expanding the universe of investment opportunities for American investors.
  • Capital Raising for Foreign Companies: ADRs provide foreign companies with a mechanism to access the vast U.S. capital markets, allowing them to raise capital directly from American investors.14
  • Simplified Trading and Settlement: ADRs trade and settle like regular U.S. stocks, using U.S. dollar pricing and U.S. settlement systems, which simplifies the trading process for investors and brokers alike.13
  • Regulatory Oversight: ADRs listed on major U.S. exchanges are subject to certain reporting and disclosure requirements of the U.S. Securities and Exchange Commission (SEC), providing a degree of regulatory oversight that might be absent when investing directly in certain foreign markets. The SEC mandates disclosures regarding fees and payments between depositary banks and foreign issuers to enhance transparency for ADR holders.12

Limitations and Criticisms

Despite their advantages, American Depository Receipts (ADRs) come with certain limitations and risks that investors should consider:

  • Currency Risk: A common misconception is that because ADRs trade in U.S. dollars, they eliminate currency risk. This is incorrect. The value of an ADR is tied to the underlying foreign shares, and thus, fluctuations in the exchange rate between the U.S. dollar and the foreign currency will impact the ADR's value and returns. A weakening foreign currency relative to the dollar will negatively affect the ADR's price, even if the underlying stock performs well in its local market.11,10
  • Double Taxation: ADR holders may face double taxation on dividends—once by the foreign country and potentially again by the U.S. government. While tax treaties and foreign tax credits can often mitigate this, it adds a layer of complexity not typically present with domestic stocks.,
    *9 Custody Fees: Depositary banks that issue and manage ADR programs typically charge ongoing custody fees, which can range from a few cents per share and are often deducted from dividend payments or passed on to the investor's brokerage firm.,
    *8 Limited Offerings: While many large foreign companies offer ADRs, the total number of foreign companies available through ADRs is limited compared to the vast universe of companies trading on their local exchanges.
  • Disclosure Differences: Although sponsored ADRs listed on major U.S. exchanges adhere to certain SEC reporting standards, the level of disclosure can still differ from that required of U.S. domestic companies. Some types of ADRs, particularly unsponsored ones, have minimal reporting requirements, which can limit the financial information available to investors.
    *7 Political and Economic Risks: ADRs are inherently exposed to the political and economic risks of the foreign company's home country, including potential government instability, changes in regulations, or macroeconomic downturns that could impact the company's performance and the ADR's value.

6## American Depository Receipt vs. Global Depository Receipt

The terms American Depository Receipt (ADR) and Global Depository Receipt (GDR) both refer to certificates that represent shares of a foreign company, allowing them to be traded outside their home market. The key distinction lies in their target markets and where they are issued.

An American Depository Receipt (ADR) is specifically designed for the U.S. market. It is issued by a U.S. depositary bank and represents shares of a non-U.S. company that trade on U.S. stock exchanges or over-the-counter. ADRs are denominated in U.S. dollars and are cleared through U.S. settlement systems, making them seamlessly tradable for American investors.

In contrast, a Global Depository Receipt (GDR) is issued by an international depositary bank and typically trades on two or more global markets simultaneously, often in Europe (e.g., London or Luxembourg). GDRs can be denominated in various currencies, most commonly U.S. dollars or Euros, and are aimed at a broader international investor base. While ADRs focus solely on enabling access to foreign stocks for U.S. investors, GDRs facilitate a wider global reach for foreign companies seeking capital from multiple international markets.

FAQs

What is the purpose of an American Depository Receipt?

The primary purpose of an American Depository Receipt (ADR) is to allow U.S. investors to easily invest in shares of foreign companyies without the complexities of cross-border trading, such as foreign currency conversions or differing settlement procedures. It also enables foreign companies to access the U.S. capital markets to raise capital or increase their investor base.

5### How do I buy an ADR?
You can buy an ADR through a standard U.S. brokerage account, similar to buying shares of a domestic company. ADRs are listed on U.S. stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ, or traded over-the-counter (OTC).

Are ADRs the same as the underlying foreign stock?

No, ADRs are not the exact same as the underlying foreign stock. An ADR is a certificate of ownership issued by a U.S. depositary bank that represents the underlying shares held by the bank in the foreign company's home country. While their value is derived from the underlying shares, they trade independently on U.S. markets and are subject to U.S. regulations and market dynamics, as well as currency exchange rates.

4### Do ADRs pay dividends?
Yes, many ADRs pay dividend payments. The dividends are typically declared by the foreign company in its local currency, converted into U.S. dollars by the depositary bank, and then paid out to the ADR holder. It's important to note that these dividends may be subject to foreign withholding taxes, although investors may be eligible for U.S. tax credits.

What are the different types of ADRs?

ADRs are generally categorized into three main levels:

  • Level I ADRs: These are the most basic and trade only on the over-the-counter (OTC) market. They have minimal SEC reporting requirements.
    *3 Level II ADRs: These can be listed on major U.S. stock exchanges and have more stringent SEC reporting requirements, including filing Form 20-F.
    *2 Level III ADRs: These allow foreign companies to raise capital in the U.S. by issuing new shares. They have the most extensive SEC reporting and disclosure requirements.
    A1dditionally, there are also "unsponsored" ADRs, which are created by a depositary bank without the direct involvement or permission of the foreign company and generally trade only OTC.