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Investing in the stock market is quite a complex task. The complexity is not just around the different risks involved but also with the various regulatory requirements. While investing in the home country requires multiple levels of supervision and approvals, imagine the tedious process involved in investing in foreign stock markets.
To ease this process, the American financial market has a unique instrument for American investors. Here is where the concept of ADR becomes relevant. In today’s article, we will learn the details of ADRs, including their features, benefits and examples.
What are American Depositary Receipts (ADRs)?
American Depositary Receipts, commonly referred to as ADRs in short, are instruments that allow American investors to invest in the stocks of foreign companies.
The uniqueness of the instrument is the facility to invest in foreign stocks from the home market. Unlike other foreign investment options, ADRs do not require investors to trade on foreign exchanges.
How do ADRs work?
Now that we know ADRs allow investors to buy shares of foreign companies from local stock exchanges, let us understand how ADRs facilitate this.
Depositary banks in the United States of America hold shares of foreign companies in their custody. In this context, any company without registration in the USA is considered foreign.
Companies willing to issue ADRs in the US must get special approval from the Securities and Exchange Commission (SEC). These shares are then available to investors through US stock exchanges like NYSE and NASDAQ. The price of such shares depends on the trading price in their home market, subject to exchange rate adjustments. The process of investing in American Depositary Receipts for American investors is as simple as investing in regular stocks on the exchange.
Since US banks hold these shares in their custody, it eliminates the trouble for investors to rely on stock exchanges of other countries for investing.
- Example
Consider a real-world example of American Depositary Receipts (ADRs).
Infosys is an Indian multinational company listed on the National Stock Exchange and the Bombay Stock Exchange. As of 19 January 2023, the shares of Infosys are trading at ₹1,657.85 on NSE. These shares are also listed as ADRs on the New York Stock Exchange. The ADR is currently trading at $19.94 (Based on the exchange rate between USD and INR).
The value of Infosys’s ADR keeps fluctuating every day based on its market price in India and the exchange rate.
Features of American Depositary Receipts
- Irrespective of the company’s local currency, ADRs are always denominated in US dollars.
- ADRs are primarily meant for US investors.
- The depositary banks holding the custody of shares are also the situation in the United States of America.
- ADRs may or may not pay dividends. Those paying the dividend pay them in US dollars.
Benefits and limitations of ADRs
Pros:
- Investing in foreign exchanges requires investors to follow the regulations of the foreign country and also take care of currency exchanges. Such procedures are not required while investing in ADRs, making foreign investments hassle-free.
- Investing in ADRs allows American investors to hold a diverse portfolio with foreign stocks.
- From the perspective of companies, ADRs allow them to raise foreign capital from the United States, even though they are not officially listed there.
Cons:
- Despite the benefits, ADRs are exposed to currency risks. Since the value of ADRs depends on the exchange rate of dollars, the investment’s worth may constantly vary.
- ADRs are directly related to the market prices of home countries. Political and economic factors in the home country influence stock prices and, in turn, the prices of ADRs.
- ADRs may or may not pay dividends. Even if they do, the rate of dividend may be lower as compared to regular stocks listed in the US market.
- ADR holders may not get voting rights in the investing company, unlike regular stockholders who get voting rights upon buying shares.
- Since ADRs are not typical stocks, the associated costs are higher, impacting the investor’s final profit.
ADRs vs GDRs
GDR stands for Global Depositary Receipt. It is another form of depositary receipt issued by depositary banks to raise capital from foreign countries.
Unlike ADRs, GDRs are listed across different countries in the world. This is the primary difference between ADRs and GDRs. While ADRs are particularly for American Investors to invest in foreign stocks, GDRs allow investors worldwide to invest in foreign stocks.
For example, an Indian company issuing depositary receipts on the London Stock Exchange is an example of GDR.
Bottomline
American Depositary receipts offer various benefits to both investors and the issuing company. While companies enjoy the ease of attracting foreign capital, investors gain the benefit of diversification along with a seamless process of investing in foreign stocks. However, ADRs are no exception to risks in the financial market. Hence, investors must assess their risk profiles thoroughly before buying ADRs.
FAQs
The two main categories of ADRs are sponsored and unsponsored ADRs. Sponsored ADRs are created when foreign companies enter into agreements with US depositary banks to list ADRs on US stock exchanges. Unsponsored ADRs are where such companies liaison with brokers and choose the OTC way, removing the requirement of SEC approval.
No, ADRs are not the same as common stocks. ADRs are certificates represented in the US dollar that trade on the stock exchange. Unlike common stocks, the holders of ADRs do not get access to voting rights or dividends.
Some ADRs provide dividends. Investors also incur capital gains upon selling ADRs on stock exchanges. So, both dividends and capital gains are taxed. The rate of tax will be the same as the rate charged on dividends and capital gains of regular US-based stocks.
This depends on the conversion ratio. While companies decide to list their stocks as ADRs in the US market, they also come up with a conversion ratio. A ratio of 2:1, for example, represents that two ADRs are equal to one ordinary share.
ADRs can be issued in the US market at three different levels. Level 1 ADRs are simple ADRs requiring less to no approvals from the SEC. Level 2 ADRs require certain levels of approvals and regulations from the SEC. Level 3 is the highest level of foreign capital that requires thorough approval from the SEC.