Depositary receipt

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What Is a Depositary Receipt?

A depositary receipt (DR) is a negotiable certificate issued by a bank that represents ownership of shares in a foreign company, allowing those shares to be traded on a local stock exchange. This financial instrument belongs to the broader category of international finance and is designed to simplify global investing for domestic investors⁵³, ⁵⁴. Depositary receipts enable investors to gain exposure to foreign companies without directly trading in international markets or dealing with foreign currency conversions⁵¹, ⁵².

Each depositary receipt is backed by an [underlying asset]—the actual shares of the foreign company—which are held by a [custodian bank] in the issuer's home country. The depositary bank then issues the receipts, which can be bought and sold just like local [equity securities] on a domestic [stock market]. Th⁴⁹, ⁵⁰e creation of depositary receipts eliminates the complexities previously involved in foreign investing, such as exchanging money into foreign currency and opening foreign brokerage accounts.

#⁴⁸# History and Origin

The concept of the depositary receipt originated in the 1920s to address the complexities U.S. investors faced when trying to acquire shares of non-U.S. companies. Before their introduction, direct investment in foreign markets was often impractical for the average American.

The first American Depositary Receipt (ADR), a specific type of depositary receipt, was pioneered by Guaranty Trust Company, a predecessor of J.P. Morgan, in 1927. Th⁴⁷is inaugural ADR represented shares of the British retail company Selfridges Provincial Stores Limited and was listed on the New York Curb Exchange, the precursor to the American Stock Exchange. Th⁴⁶is innovation allowed U.S. investors to buy and sell foreign shares as if they were domestic securities, facilitating cross-border investment and marking a significant moment in the evolution of [capital markets].

#⁴⁵# Key Takeaways

• A depositary receipt is a certificate representing shares of a foreign company, traded on a local stock exchange.
• They simplify international investing by allowing investors to avoid foreign currency exchange and international brokerage accounts.
• ⁴³, ⁴⁴ Depositary receipts enhance portfolio diversification by providing access to global companies and markets.
• ⁴¹, ⁴² The most common type is the American Depositary Receipt (ADR), which trades on U.S. exchanges.
• ⁴⁰ While offering convenience, depositary receipts carry unique risks, including [currency risk] and [political risk].

#³⁸, ³⁹# Interpreting the Depositary Receipt

Interpreting a depositary receipt involves understanding its relationship to the underlying foreign shares. A depositary receipt's price generally tracks the price of the foreign security in its home market, adjusted for the ratio of receipts to foreign company shares. For example, one depositary receipt might represent one, a fraction of one, or multiple shares of the foreign stock. Th³⁷is ratio is crucial for accurately assessing the value of the depositary receipt in relation to its true underlying equity.

Investors can use depositary receipts to gain exposure to global companies, making it easier to diversify an [investment portfolio] internationally. Th³⁵, ³⁶e value of the depositary receipt will fluctuate based on the performance of the foreign company, as well as movements in [foreign exchange] rates between the local currency of the receipt and the currency of the underlying shares.

#³³, ³⁴# Hypothetical Example

Imagine an investor in the United States, Sarah, wants to invest in a growing technology company based in Japan, but she does not want to deal with the complexities of opening a brokerage account in Japan or converting U.S. dollars to Japanese Yen for each transaction.

Instead, Sarah looks for a depositary receipt representing shares of the Japanese tech company that trades on a U.S. exchange. She finds that a U.S. depositary bank has issued American Depositary Receipts (ADRs) for this company, with each ADR representing five ordinary shares of the Japanese company.

If the Japanese company's shares are trading at ¥1,000 per share in Tokyo, and the exchange rate is ¥150 to $1 USD, the underlying value of one ADR would be calculated as:

Value of 1 ADR = (Price per Japanese share * Number of Japanese shares per ADR) / Exchange Rate
Value of 1 ADR = (¥1,000 * 5) / ¥150
Value of 1 ADR = ¥5,000 / ¥150
Value of 1 ADR = $33.33

Sarah can then buy and sell these ADRs on a U.S. exchange through her domestic brokerage account, receiving [dividend payments] in U.S. dollars, all without directly engaging with the Japanese stock market.

Practical Applications

Depositary receipts are widely used [financial instruments] that allow companies to access international capital and enable investors to participate in foreign markets. Their practical applications span several areas:

• International Investment Access: Depositary receipts, particularly ADRs and Global Depositary Receipts (GDRs), offer a streamlined way for investors to buy shares of companies located outside their home country. This acc³¹, ³²essibility can significantly broaden an investor's universe for [diversification] and growth opportunities.
• Capital Raising for Foreign Companies: Non-U.S. companies use depositary receipt programs to raise capital from investors in other countries, particularly in the U.S. and European markets. This pro³⁰vides an additional source of funding beyond their domestic markets. For instance, in the first half of 2008, trading in UK ADRs totaled $199 billion, highlighting their role in attracting foreign capital.
• Arb²⁹itrage Opportunities: Discrepancies between the price of a depositary receipt and its underlying shares in the home market can create arbitrage opportunities for sophisticated traders, helping to keep prices aligned across different markets.
• Si²⁸mplified Corporate Actions: The depositary bank handles various corporate actions, such as [dividend payments] and stock splits, on behalf of the depositary receipt holders, simplifying the process for international investors.

Limi²⁷tations and Criticisms

While depositary receipts offer numerous advantages, they also come with certain limitations and criticisms that investors should consider:

• Currency Risk: One significant drawback is exposure to [currency risk]. Even tho²⁵, ²⁶ugh depositary receipts are denominated in the local currency of the trading exchange (e.g., U.S. dollars for ADRs), the value of the underlying foreign shares is subject to fluctuations in the exchange rate between the two currencies. A weaken²⁴ing foreign currency relative to the investor's home currency can erode the value of the investment, even if the foreign company's performance remains strong.
• Po²³litical and Economic Risks: Investing in depositary receipts means exposure to the [political risk] and economic instability of the foreign company's home country. Changes ²¹, ²²in government policies, regulations, or economic downturns in that country can directly impact the value of the depositary receipt.
• Fe¹⁹, ²⁰es and Expenses: Depositary receipts can incur additional fees, such as custodial service fees charged by the depositary bank. These "p¹⁷, ¹⁸ass-through fees" compensate the agent bank for services like holding the underlying shares and processing dividends, and typically range from $0.01 to $0.05 per ADR per dividend. There ma¹⁶y also be currency conversion fees and higher administrative costs compared to direct investment.
• Li¹⁴, ¹⁵mited Liquidity and Information: Some depositary receipts, particularly unsponsored ones or those not listed on major exchanges, may have relatively low [liquidity], making it difficult to buy or sell them quickly without impacting the price. Additionally, the level of financial disclosure from foreign companies can vary, and some programs (like Level 1 ADRs) have minimal reporting requirements with the U.S. Securities and Exchange Commission (SEC).

Depo¹², ¹³sitary Receipt vs. Global Depositary Receipt

While "depositary receipt" is a general term, Global Depositary Receipts (GDRs) are a specific type often confused with the broader category. The key distinction lies in their market reach and listing venues.

A depositary receipt broadly refers to any negotiable certificate issued by a bank that represents ownership of shares in a foreign company and trades on a local stock exchange. American Depositary Receipts (ADRs) are the most common type of depositary receipt, specifically designed for U.S. investors and traded on U.S. exchanges.

In cont¹¹rast, a Global Depositary Receipt (GDR) provides broader market exposure. GDRs are typically offered to investors in two or more markets, often including both the U.S. and European markets. They are¹⁰ commonly used by foreign companies seeking to raise capital in multiple international jurisdictions simultaneously. While AD⁹Rs are focused on the U.S. market, GDRs aim for a wider global reach, making them a fungible security across different international exchanges. Both are types of [derivatives] that simplify cross-border investment, but their primary listing and trading locations differ.

FAQs

What is the primary purpose of a depositary receipt?

The primary purpose of a depositary receipt is to simplify investing in foreign companies for domestic investors. It allows individuals to purchase shares of a non-U.S. company on their local stock exchange without dealing with foreign currency or international trading regulations.

Are⁷, ⁸ depositary receipts the same as owning regular shares?

Not exactly. A depositary receipt represents an ownership interest in underlying shares held by a depositary bank, but it is not the actual share of the foreign company itself. While AD⁶Rs track the price of the foreign company's domestic shares, they do not always grant the same direct ownership rights as common stock. However, depositary receipt holders have the right to obtain the underlying foreign security.

How do depositary receipts pay dividends?

When the foreign company pays a dividend to its shareholders, the depositary bank receives these [dividend payments] in the foreign currency. The bank then converts these dividends into the local currency of the depositary receipt (e.g., U.S. dollars for ADRs), deducts any fees or applicable foreign taxes, and distributes the net amount to the depositary receipt holders.

Can⁵ all foreign companies issue depositary receipts?

No, not all foreign companies issue depositary receipts. The decision to issue them depends on various factors, including the company's interest in attracting foreign investors, its willingness to comply with the disclosure and reporting requirements of the target market's regulatory bodies (like the SEC in the U.S.), and the demand from depositary banks and investors.

Wha², ³, ⁴t is the role of a depositary bank?

A depositary bank plays a crucial role in a depositary receipt program. It issues the depositary receipts, holds the underlying foreign shares, facilitates currency conversions, processes dividend payments, and manages various administrative and regulatory aspects on behalf of the investors and the foreign company.¹