Menu
sharewise sharewise
Log in
Sign up
Log in
Sign up
Microsoft strongly encourages users to switch to a different browser than Internet Explorer as it no longer meets modern web and security standards. Therefore we cannot guarantee that our site fully works in Internet Explorer. You can use Chrome or Firefox instead.

Dictionary

Understanding American Depositary Receipts (ADRs)

Picture this: an investor in the United States wants to invest in a company headquartered in Brazil. Can this transaction happen seamlessly? Yes, it can! The answer lies in a financial term named 'American Depositary Receipts' or ADRs.

A Brief Introduction to ADRs

American Depositary Receipts (ADRs) are financial instruments that allow investors to invest in foreign companies without the hassle and complications of dealing with foreign stock exchanges or currency conversions. These instruments were initially introduced in 1927 by the U.S. banking giant, J.P. Morgan, in order to simplify the investment process in foreign equities. ADRs can be traded on American stock exchanges, just like stocks of US-based companies, and are an excellent way to diversify investment portfolios with global exposure.

How Do ADRs Work?

A more in-depth understanding of the ADR mechanism is beneficial for investors. ADRs are issued by American-based depositary banks and are traded on U.S. stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ. Each ADR represents a specific number of underlying foreign shares, also known as a ratio.

For example, one ADR may be equivalent to four underlying shares of a foreign company, with the value of the ADR adjusting to any fluctuations in the foreign stock. Therefore, an investor purchasing an ADR acquires the economic benefits of owning the underlying foreign shares without physically owning the shares themselves.

The depositary bank acts as an intermediary, issuing ADRs in the US and purchasing shares from the foreign company in its home country. These shares are then held in custody and are used to back the ADRs issued on the U.S. market.

Types of ADRs

There are three types of American Depositary Receipts, with each type having its own implications and requirements for issuance.

  1. Sponsored ADRs: These ADRs are created through an agreement between a foreign company and a US depositary bank, wherein the foreign company is involved in both the issuance and ongoing compliance activities. Sponsored ADRs can be further categorized into three levels:

  • Level I ADRs are traded over the counter, specifically on the OTC market, and typically do not require the foreign company to conform to U.S. Generally Accepted Accounting Principles (GAAP).

  • Level II ADRs are listed on a national U.S. stock exchange and require the foreign company to register with the U.S. Securities and Exchange Commission (SEC), file annual reports, and conform to GAAP.

  • Level III ADRs involve the foreign company issuing new shares in order to raise capital. They are subject to stringent SEC and stock exchange regulations, including strict financial reporting standards.

  1. Unsponsored ADRs: These ADRs are issued by depositary banks without the sponsorship or direct involvement of the foreign company. Unsponsored ADRs are traded over the counter and may involve multiple depositary banks, resulting in multiple ADRs for the same foreign company, with different trading ratios and fees.

  2. Global Depositary Receipts (GDRs): Although not a type of ADR, it's important to mention GDRs, which are similar instruments that allow international investors to invest in foreign companies by depositing shares in various countries, not just the United States. GDRs are typically traded on European and Asian exchanges, offering a broader scope for global investment.

Advantages of ADRs

Investing in ADRs comes with multiple benefits that attract investors to this type of financial instrument:

  • Diversification: ADRs allow investors to add exposure to foreign markets, reducing the risk associated with focusing solely on domestic investments.
  • Ease of investment: ADRs streamline the trading process by being traded in U.S. exchanges and in U.S. dollars, eliminating the need for complex foreign exchange transactions and other cross-border complexities.
  • Transparency: At least in the case of Level II and Level III ADRs, compliance with U.S. SEC regulations offers a degree of confidence in the financial information provided by the foreign companies.
  • Liquidity: ADRs are traded on U.S. stock exchanges, providing easy access for American investors and generally higher trading volumes compared to the foreign shares.

Risks and Disadvantages of ADRs

However, it's important to consider some potential drawbacks and risks associated with ADRs:

  • Currency risk: While ADRs are traded in U.S. dollars, the underlying shares are still subject to fluctuations in the foreign currency. This can introduce volatility in the ADR's value due to currency fluctuations.
  • Political risk: Investors should consider any potential issues arising from political changes or instability in the country in which the foreign company operates.
  • Limited selection: While ADRs provide an opportunity for global investment, not all foreign companies have ADRs available, thus limiting the choices for investors.

In conclusion, American Depositary Receipts serve as a convenient way for investors to diversify their portfolios with international exposure. Understanding the mechanism behind ADRs and the associated benefits and risks is essential for making informed investment decisions when considering global investments.

Feedback