What are American Depositary Receipts (ADR)?
An American Depositary Receipt represents shares in a foreign company traded on U.S. exchanges, for instance, the New York Stock Exchange (NYSE) or NASDAQ.
Every ADR represents one or more shares of a foreign company. However, some ADRs represent a fraction of a share. Such receipts are issued by the U.S. depositary banks that hold the actual shares of the foreign companies in custody. That means that ADRs allow investors in America to tap directly into foreign equities without having to deal directly with the international markets, employing foreign languages, regulations, and currencies.
ADRs were invented in the 1920s to facilitate U.S. investors to invest in British shares. Through time, this became one of the most significant tools employed in international finance to enable Americans to diversify their portfolios by investing in famous companies located within countries like Japan, the United Kingdom, Germany, and China. Firms such as Toyota, Samsung, and Alibaba, whose overseas brands are famous, also offer ADRs, making it easy for U.S. investors to support global giants without leaving their domestic exchange.
An ADR that trades in the U.S. market is priced based on the non-U.S. company’s shares price in their home market. This price is regularly adjusted for the varying forex spot rates. Hence, there is a high degree of volatility in ADR prices. ADR prices are also affected by the home country’s accounting, legal and political differences.
How Do ADRs Work?
The process of an ADR is initiated when a foreign company wishes to offer its shares to U.S. investors. An agreement is reached between the foreign company and a domestic bank to issue ADRs in the U.S. market. The bank will buy shares in the foreign company and hold them in its custody. Then, for each block of shares it holds, it issues ADRs in the U.S. market. Each ADR has a stated ratio compared to the underlying shares, although in general, it is one ADR for one share but in some cases, several ADRs might represent just one share or portions of a share depending on the agreement.
The investors who purchase ADRs remain vulnerable to the same price fluctuations as that of the underlying security. ADRs will generally pay out dividends, if they have one, in which case the dividends are converted into U.S. dollars, making it easier for U.S.-based investors to take income in their domestic currency. Secondly, ADRs are regulated by the U.S. Securities and Exchange Commission (SEC), hence providing investors with some protections and rules that resemble what they are used to.
Also Read: What is a Hedge Fund – Meaning and Purpose
Types of ADRs
There are three main types of ADRs, categorized by the level of involvement and regulatory compliance between the foreign company and the U.S. financial markets:
markets:
Level I ADRs
Level I ADRs are the simplest type of ADRs and are traded over-the-counter, rather than on the major U.S. exchanges. They require only minimal regulatory requirements so the issuing foreign company is not necessarily committed to following U.S. accounting standards as a requirement. However, Level I ADRs allow investors to gain access to foreign companies that are not committed to entering the U.S. capital markets.
Level II ADRs
Level II ADRs are traded on US exchanges such as NYSE or NASDAQ. Level II ADRs are sure to face stiffer regulatory requirements, including the SEC’s requirement for disclosure. Although level II ADRs require more reporting, this increases transparency and investor confidence, hence more investors will be attracted to the ADRs.
Level III ADRs
Level III ADRs are the most superior levels and permit foreign firms to directly raise capital from US investors by issuing new shares. These firms undergo the most rigorous form of regulatory scrutiny, which also incorporates inclusive reporting and financial disclosure, almost identical to that of the companies based in the US. Level III ADRs tend to represent large, established companies with a well-entrenched commitment to the US market and are traded on major exchanges.
What are the benefits of investing in ADRs?
American depositary receipts allow investors to diversify their portfolios and earn returns from foreign companies. They also offer investors the opportunity to invest in companies that might be otherwise inaccessible.
Another benefit of ADRs is that they trade in real time on major U.S. stock exchanges, which makes them more liquid than foreign stocks. And, because they are denominated in U.S. dollars, investors don’t have to worry about currency risk.
Conclusion
American Depositary Receipts provide a fairly straightforward means by which the U.S. investor can move overseas in search of diversity without hassle over foreign exchange transactions. ADRs offer alternatives at levels across the board, thereby an ADR to suit everyone’s desires; from minimal involvement from the regulatory bodies to those keen on companies committed to absolute transparency. Despite risks attached to ADRs, they are one of the most accessible and regulated ways by which U.S. investors can gain global exposure while exploring possibilities offered by foreign markets.