American depositary receipts (ADRs): Explained | TIOmarkets

BY TIO Staff

|June 28, 2024

In the world of trading and finance, American Depositary Receipts (ADRs) play a pivotal role in providing investors with the opportunity to own shares in foreign companies without the complexities and risks associated with buying shares directly on a foreign market. ADRs, essentially, are certificates issued by U.S. banks that represent a certain number of shares of a foreign stock.

ADRs are a financial instrument that allows investors to gain exposure to foreign markets while avoiding many of the barriers typically associated with investing in foreign securities. They are traded on U.S. exchanges just like regular stocks, and are subject to the same regulations and protections. This article will delve into the intricacies of ADRs, their benefits, and potential drawbacks.

History of ADRs

The concept of ADRs was first introduced in the 1920s by J.P. Morgan. The bank issued the first ADR in 1927 for the British retailer Selfridges. The primary goal was to provide American investors with a simple and secure way to invest in foreign companies. Since then, ADRs have grown in popularity and are now a common tool for investing in foreign companies.

Over the years, ADRs have evolved and adapted to meet the changing needs of investors and the global economy. Today, they are a crucial component of the global financial system, providing a bridge between different countries' stock markets and enabling cross-border investment.

Types of ADRs

There are three main types of ADRs: Level I, Level II, and Level III. Each level represents a different degree of risk and compliance with U.S. securities laws.

Level I ADRs are the most basic type and are not listed on a U.S. exchange. They are traded over-the-counter and carry the highest level of risk. Level II ADRs are listed on a U.S. exchange and must comply with more stringent SEC regulations. Level III ADRs are also listed on a U.S. exchange, but in addition, the foreign company can raise capital through a public offering of ADRs.

Benefits of ADRs

ADRs offer several benefits to investors. Firstly, they provide a convenient way to invest in foreign companies without having to deal with foreign exchange rates, language barriers, and other complexities of investing directly in a foreign market.

Secondly, ADRs are traded just like regular stocks on U.S. exchanges, making them accessible to a wide range of investors. They also offer the potential for diversification, as they allow investors to invest in companies from a variety of sectors and countries.

Risks of ADRs

While ADRs offer many benefits, they also come with certain risks. One of the main risks is currency risk. Since ADRs represent shares in a foreign company, changes in the foreign currency exchange rate can affect the value of the ADR.

Another risk is country risk. This refers to the risk that economic, political, or social conditions in the foreign country could negatively impact the value of the ADR. Additionally, ADRs may not offer the same level of protection as investing in U.S. stocks, as they are subject to the laws and regulations of the foreign country.

Trading ADRs

Trading ADRs is similar to trading regular stocks. They can be bought and sold through a brokerage account, and their price is quoted in U.S. dollars. However, there are some unique aspects to trading ADRs that investors should be aware of.

One unique aspect is the ADR ratio, which represents the number of foreign shares that each ADR represents. This ratio can vary widely, and it's important for investors to understand this ratio before investing in an ADR.

Dividends and Taxes

ADRs can also pay dividends, just like regular stocks. However, these dividends are usually paid in the foreign currency and then converted into U.S. dollars by the depositary bank. This can result in foreign exchange risk, as changes in the exchange rate can affect the amount of the dividend.

When it comes to taxes, ADRs can be more complex than regular stocks. Investors may be subject to foreign taxes on dividends, and there may also be U.S. tax implications. It's important for investors to consult with a tax advisor before investing in ADRs.

Conclusion

ADRs offer a unique opportunity for investors to gain exposure to foreign markets without the complexities and risks associated with investing directly in foreign stocks. However, like all investments, they come with risks and should be considered as part of a diversified portfolio.

As with any investment, it's important to do your research and understand the risks before investing in ADRs. This includes understanding the ADR ratio, the potential for currency and country risk, and the tax implications of investing in ADRs.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.