American Depositary Receipts (ADRs) allow U.S. investors to buy shares of foreign companies without dealing with the complexities of foreign exchanges or currencies. Simply put, ADRs are certificates issued by U.S. banks representing foreign company shares. These certificates trade on U.S. stock markets just like regular U.S. stocks.

ADRs are a convenient option for both U.S. investors and foreign companies. U.S. investors can easily invest in overseas companies without opening a foreign brokerage account or worrying about foreign regulations. Meanwhile, foreign companies can attract American investors and raise capital in the U.S. without the hassle of listing on U.S. stock exchanges.

How Do ADRs Work?

Here’s how ADRs work in a nutshell:

• A U.S. bank buys shares from a foreign company’s stock exchange.

• The bank holds these shares as inventory.

• It then issues ADRs representing those shares for trading on U.S. markets.

ADRs are priced in U.S. dollars, trade on major U.S. exchanges like the NYSE and NASDAQ, and even pay dividends in dollars, making them easy for U.S. investors to handle.

For example, if you want to buy shares in a company from Japan, the ADR process allows you to do this in the U.S., with transactions handled in dollars instead of yen. The bank that holds the original shares converts dividends and manages any currency exchange.

Types of ADRs

There are two main types of ADRs: Sponsored and Unsponsored.

Sponsored ADRs

In a sponsored ADR, the foreign company works directly with a U.S. bank to issue the ADRs. The company is involved in the process, which means it’s responsible for providing financial information and following U.S. regulations. Sponsored ADRs are the most common type and can be listed on U.S. stock exchanges, providing more visibility and credibility to the company.

Unsponsored ADRs

In unsponsored ADRs, a U.S. bank issues the ADRs without the foreign company’s involvement. These ADRs are traded over-the-counter (OTC) instead of on major exchanges. Unsponsored ADRs might come with different terms, such as varying dividend amounts. They do not include voting rights, and the foreign company doesn’t manage the ADR.

Levels of ADRs

ADRs come in three levels, depending on how much access the foreign company has to U.S. financial markets.

Level I ADRs

Level I ADRs are the most basic type and are traded OTC. Foreign companies with Level I ADRs meet the least reporting requirements and do not list on major U.S. exchanges. These ADRs allow companies to test the U.S. market without regulatory hassle.

Level II ADRs

Level II ADRs are a step up. They are listed on major U.S. exchanges like the NASDAQ or NYSE and must comply with more strict reporting and regulatory requirements from the SEC. Level II ADRs provide higher visibility and usually attract more trading volume.

Level III ADRs

Level III ADRs are the highest and most prestigious level. Foreign companies can raise capital by floating a public offering of ADRs on a U.S. exchange. These companies must meet all SEC reporting requirements, including filing detailed financial reports. Many well-known international companies, like Vodafone and Petrobras, have Level III ADRs.

Advantages of ADRs

ADRs come with several benefits for U.S. investors and foreign companies:

• Easy to Trade: ADRs trade on U.S. exchanges like any other stock, making them easy to buy and sell.

• Diversification: ADRs give U.S. investors access to foreign companies and help diversify their portfolios.

• Dividends in Dollars: Investors receive U.S. dividends, eliminating the need to deal with foreign currencies

• Accessibility: U.S. investors can invest in foreign companies easily without needing a foreign brokerage account or dealing with foreign regulations.

Disadvantages of ADRs

ADRs have some drawbacks, despite their benefits:

• Double Taxation: Investors may pay taxes on dividends and capital gains in both the U.S. and the foreign country.

• Limited Selection: Not all foreign companies offer ADRs, so that investors may have limited options.

• Fees: ADRs often come with extra fees, such as custody fees charged by the bank holding the foreign shares.

• Currency Risk: Changes in the foreign country’s currency value impact ADR prices, even when banks price them in U.S. dollars.

How Banks Price ADRs

The price of the foreign company’s stock in its home country determines the cost of an ADR. The U.S. bank sets the ratio of ADRs to foreign shares to make the price appealing to U.S. investors. For instance, one ADR might represent one share of a foreign stock or multiple shares depending on the value of the foreign stock.

The price of an ADR will generally track the foreign stock’s price, considering exchange rate fluctuations. The ADR’s value changes directly when the exchange rate between the U.S. dollar and the foreign currency shifts, even though it trades in U.S. dollars.

History of ADRs

ADRs were introduced in the 1920s to make it easier for U.S. investors to buy foreign stocks. Before ADRs, U.S. investors had to deal with foreign exchanges and currencies, making the process complicated and expensive.

In 1927, J.P. Morgan’s predecessor, Guaranty Trust, created the first ADR for shares of the British retailer Selfridges. Since then, ADRs have grown in popularity, and today, there are over 2,000 ADRs representing companies from more than 70 countries.

Conclusion

American Depositary Receipts (ADRs) offer a simple way for U.S. investors to buy shares of foreign companies. By issuing certificates representing foreign shares, U.S. banks make it easy for investors to trade them like any domestic stock. ADRs enable foreign companies to access U.S. markets and give investors a chance to diversify their portfolios. Investors continue to favor ADRs, despite the risks and fees, when seeking global opportunities.