What it means
The structure is simple once you see the layers. A depositary bank buys or holds shares of the foreign company in its home market, places them with a local custodian, and issues receipts against them in the United States.
Each receipt represents a fixed number of underlying shares, called the ADR ratio, which might be one, two, five or a fraction of a share. The main appeal is convenience.
Investors get dollar pricing, dollar dividends, US settlement rules and English-language reporting, which removes most of the friction of buying a foreign share directly. For the issuing company, an ADR programme widens the shareholder base and can raise the profile of the business with American institutions.
ADRs come in levels that determine what the company must do. A Level I programme trades over the counter with minimal disclosure, Level II involves a US exchange listing and fuller reporting, and Level III supports an actual capital raise in the United States.
Each step upward brings more investor access and more compliance cost. Pricing follows a straightforward relationship.
The ADR should trade at the home share price multiplied by the ratio, converted into dollars at the prevailing exchange rate, and when it drifts away from that value arbitrageurs create or cancel receipts until the gap closes. This means an ADR investor carries currency risk whether or not they ever touch a foreign currency directly.
There are costs and quirks to watch. Depositary banks charge a small custody fee, often deducted from dividends, foreign withholding tax may apply before the dividend reaches the investor, and thinly traded receipts can have wide spreads.
None of these are large individually, but they explain why an ADR return can lag the home-market share return slightly.
In practice
Real-world examples.
Example
A US pension fund wants exposure to a Japanese carmaker but its mandate forbids holding securities that settle outside the United States. It buys the company's ADRs instead, obtaining the same economic exposure inside its permitted settlement rules.
Example
A Brazilian mining group establishes a Level III programme and raises $700,000,000 from American institutions. The listing brings audited reporting under US requirements, which the company's chief financial officer describes as the real cost of the capital.
Example
A retail investor holds ADRs in a European bank and receives a dividend that is smaller than expected. Checking the statement, they find foreign withholding tax and a $0.03 per receipt depositary fee were deducted before the dollars arrived.
Formula
Calculation
Fair ADR price = Home share price x ADR ratio x Exchange rate (dollars per unit of foreign currency)
A European manufacturer's ordinary shares trade in Frankfurt at 25.00 euros. Its ADR programme uses a ratio of two ordinary shares per receipt, and the exchange rate is $1.10 per euro.
Fair ADR price = 25.00 x 2 x 1.10 = $55.00
If the receipt is quoted at $54.20 in New York, it is trading at a discount of $0.80, or 1.5% below fair value, and a bank can profit by buying receipts, cancelling them and selling the underlying shares in Frankfurt until the gap closes. Note also that an investor holding 1,000 of these receipts and facing a depositary fee of $0.02 per receipt pays $20 in custody charges, typically netted off the dividend.Case study
Seen in the real world.
This illustrative and entirely fictional example follows Meridian Kestrel, a mid-sized speciality chemicals company listed in London. Its board wanted more American institutional shareholders, having noticed that two thirds of its revenue came from North America while barely 5% of its register did.
The company began with an unsponsored Level I facility that a depositary bank had already created, then moved to a sponsored Level II programme with a US exchange listing. The ratio was set at four ordinary shares per receipt so that the dollar price landed in a range familiar to American investors rather than at a few dollars per receipt. Compliance and reporting costs rose by roughly $1,400,000 a year.
Within three years, US holders had grown from 5% to 22% of the register and the shares traded on a noticeably narrower spread. The finance director's internal review concluded that the programme paid for itself, but stressed a point often missed: the receipts did not remove currency risk for American holders, they simply moved it out of sight into the daily conversion of the London price.
Watch out
Common mistakes.
- Believing an ADR removes currency risk. The receipt is priced in dollars, but its value tracks the home share price converted at the current exchange rate, so a weakening foreign currency reduces the dollar value directly.
- Assuming one receipt equals one share. Ratios vary widely, and comparing a headline ADR price with a home-market share price without applying the ratio produces nonsense.
- Ignoring depositary and withholding charges. These fees are small but recurring, and they explain most of the gap between an ADR's total return and the underlying share's total return.
Questions
People also ask.
Are ADR holders entitled to vote?
Usually indirectly, since the depositary bank holds the legal title and votes on instruction from receipt holders, though some unsponsored programmes offer no voting facility at all.
What is the difference between a sponsored and an unsponsored programme?
A sponsored programme is created with the foreign company's agreement and cooperation, while an unsponsored one is set up by a depositary bank on its own initiative.
Is a Global Depositary Receipt the same thing?
The structure is the same, but a Global Depositary Receipt is typically issued into several markets outside the United States, most commonly in London or Luxembourg.
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