Understanding American Depositary Receipts (ADRs)
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Summary:
American Depositary Receipts (ADRs) provide U.S. investors with a convenient way to invest in foreign companies without the complexities of owning foreign shares directly. ADRs are certificates issued by U.S. banks that represent a specified number of shares of a foreign company.
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What Is American Depositary Receipt (ADR)
An American Depositary Receipt (ADR) is a negotiable certificate that represents a specific number of shares in a foreign company. The ADR is issued by a U.S. bank, which purchases the foreign shares and deposits them with a custodian bank in the home country. The U.S. bank then issues ADRs to U.S. investors, who can trade them on U.S. exchanges just like domestic stocks.
How ADRs work
ADRs allow U.S. investors to invest in foreign companies without the complications of owning foreign shares directly. ADRs are traded on U.S. exchanges just like domestic stocks, and their prices are quoted in U.S. dollars. ADRs provide U.S. investors with an easy and convenient way to invest in foreign companies, while avoiding the need to navigate foreign markets and currencies.
Types
There are three types of ADRs:
- Sponsored ADRs: These are the most common type of ADRs. They are created by a foreign company that wishes to have its shares traded in the U.S. market. The company must appoint a depositary bank, which will then issue the ADRs on behalf of the company.
- Unsponsored ADRs: These ADRs are created by a third party, usually a U.S. broker-dealer, without the involvement of the foreign company. Unsponsored ADRs are often created to satisfy investor demand for a particular foreign stock.
- Global Depository Receipts (GDRs): GDRs are similar to ADRs, but they are issued by non-U.S. depositary banks and are traded in markets outside the United States. GDRs are typically used to raise capital in foreign markets.
Pricing and costs
The price of an ADR is determined by supply and demand, just like any other stock. However, there are additional costs associated with owning ADRs, including:
- Depositary fees: The depositary bank charges fees for issuing and canceling ADRs, as well as for distributing dividends.
- Foreign exchange fees: When the ADR is converted to U.S. dollars, foreign exchange fees may apply.
- Custodial fees: The custodian bank charges fees for safekeeping the foreign shares.
Taxes
Dividends received from ADRs are subject to U.S. income tax, just like dividends received from domestic stocks. In addition, foreign taxes may apply to ADR dividends. ADR holders are also subject to capital gains tax when they sell their ADRs.
Advantages and disadvantages
ADRs have several advantages for U.S. investors:
- Diversification: ADRs provide U.S. investors with an easy way to diversify their portfolios with international exposure.
- Convenience: ADRs are traded on U.S. exchanges, which makes them easy to buy and sell.
- Familiarity: ADRs are denominated in U.S. dollars and are subject to U.S. accounting and disclosure requirements, which makes them familiar to U.S. investors.
In addition to the benefits, ADRs also have some disadvantages that investors should be aware of:
- Currency risk: ADRs are subject to currency risk, meaning changes in the exchange rate between the U.S. dollar and the foreign currency can affect the value of the ADR.
- Political risk: Investing in ADRs of companies located in countries with unstable political environments can be risky due to potential changes in regulations or government policies.
- Liquidity risk: Some ADRs may have low trading volumes, which can make it difficult to buy or sell shares at a desired price.
It’s important for investors to carefully consider these factors before investing in ADRs, as well as conduct thorough research on the company and its financials.
History
ADRs were first introduced in the 1920s as a way for U.S. investors to invest in foreign companies. However, it wasn’t until the 1960s that ADRs became popular and widely used. Today, ADRs are traded on major U.S. stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, and provide investors with a convenient way to invest in foreign companies.
Real-World example
One example of an ADR is Alibaba Group Holding Limited, a Chinese e-commerce company. Alibaba’s ADRs are traded on the NYSE under the ticker symbol “BABA. Each ADR represents one ordinary share of Alibaba.
ADR FAQs
What is the difference between an ADR and a foreign stock?
An ADR is a certificate representing shares of a foreign company that is held by a U.S. bank, while a foreign stock is a share of a foreign company that is traded on a foreign exchange.
How are ADRs priced?
ADRs are priced in U.S. dollars and are based on the price of the foreign company’s stock in its home market, adjusted for exchange rates and fees.
Are ADRs subject to U.S. taxes?
Yes, ADRs are subject to U.S. taxes, including capital gains taxes and dividend taxes.
Key takeaways
- ADRs are negotiable certificates issued by U.S. banks that represent a specific number of shares in a foreign company and allow U.S. investors to invest in foreign companies without owning foreign shares directly.
- There are three types of ADRs: sponsored ADRs, unsponsored ADRs, and global depository receipts (GDRs). Each type has its own advantages and disadvantages.
- ADRs offer several benefits for U.S. investors, including diversification, convenience, and familiarity, but also come with risks such as currency and political risk. It’s important for investors to carefully consider these factors before investing in ADRs.
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