American depositary receipt (ADR)

Definition

An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares in a foreign company’s stock. 

What is an American depositary receipt?

ADRs are traded on U.S. stock exchanges and allow investors to own and trade shares in foreign companies without the need to directly purchase shares on foreign stock exchanges.

The primary purpose of ADRs is to facilitate investment in foreign companies for U.S. investors. By purchasing ADRs, investors can gain exposure to international markets and diversify their portfolios without dealing with the complexities and potential barriers of investing directly in foreign stocks.

Types of ADR programs:

• Sponsored ADRs: Issued with the cooperation and involvement of the foreign company. The company directly appoints a depositary bank to establish the ADR program, typically for the purpose of raising capital or enhancing its visibility and liquidity in the U.S. market.
• Unsponsored ADRs: Established without the involvement or cooperation of the foreign company. Third-party financial institutions create unsponsored ADRs based on the shares of the foreign company that they buy on the open market. Unsponsored ADRs are generally created in response to investor demand and do not require the consent or participation of the foreign company.

Levels of ADRs:

• Level I ADRs: These are the simplest form of ADRs and are traded on the over-the-counter (OTC) market. They do not require SEC registration or full compliance with U.S. reporting standards.
• Level II ADRs: These ADRs are listed on a U.S. stock exchange and are subject to SEC registration and reporting requirements. 
• Level III ADRs: These ADRs are also listed on a U.S. stock exchange and are subject to the most stringent SEC registration and reporting requirements. 

ADRs allow investors to diversify their portfolios by investing in foreign companies across different sectors and regions. While ADRs offer benefits, they also come with risks, including currency risk, political risk, and the risk of fluctuations in the underlying foreign stock’s value.

Example of an American depositary receipt

John, an U.S. investor, wants to invest in a Japanese company called XYZ Corporation, but he prefers not to directly purchase shares on the Tokyo Stock Exchange. Instead, he decides to buy ADRs of XYZ Corporation, which are listed on the New York Stock Exchange (NYSE).

John purchases 100 ADRs of XYZ Corporation through his U.S. brokerage account. Each ADR represents 5 shares of XYZ Corporation’s stock. Therefore, John effectively owns 500 shares of XYZ Corporation through the ADRs.

By investing in ADRs, John diversifies his portfolio with international exposure while avoiding the complexities and risks associated with directly investing in foreign stocks traded on foreign exchanges.