American Depositary Receipts (ADRs)

Investing internationally can be complex—different currencies, foreign exchanges, varying regulations, and time zone challenges. American Depositary Receipts (ADRs) solve these problems by allowing U.S. investors to buy foreign stocks as easily as domestic ones. For the SIE exam, you need to understand how ADRs work and their unique characteristics.

What Is an ADR?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing shares of a foreign company. ADRs trade on U.S. exchanges in U.S. dollars, just like domestic stocks.

How ADRs Work

1. A foreign company wants its shares available to U.S. investors
2. A U.S. depositary bank purchases shares of the foreign company
3. The bank holds these shares in a foreign custodian bank
4. The depositary bank issues ADRs representing these underlying shares
5. ADRs trade on U.S. markets (NYSE, NASDAQ, or OTC)

ADR Structure

Why ADRs Exist

ADRs benefit both investors and foreign companies:

Benefits for U.S. Investors

• Trade in U.S. dollars - No currency conversion needed to buy
• Trade on U.S. exchanges - Familiar trading hours and processes
• Receive dividends in U.S. dollars - Bank handles conversion
• U.S. regulatory oversight - SEC registration and disclosure requirements
• Easier settlement - Standard T+2 settlement like domestic stocks

Benefits for Foreign Companies

• Access U.S. capital markets - Reach American investors
• Increased visibility - Presence on major U.S. exchanges
• Diversified shareholder base - Broader investor pool
• Enhanced prestige - Association with U.S. market standards

Types of ADRs

ADRs are classified by their level of SEC registration and where they trade:

Sponsored vs. Unsponsored ADRs

Levels of Sponsored ADRs

Key Point: Only Level III ADRs can raise new capital in the U.S. through public offerings.

ADR Ratio

The ADR ratio specifies how many foreign shares each ADR represents. This ratio is set to price ADRs in a range appealing to U.S. investors.

Examples of ADR Ratios

Example: A Japanese stock trades at ¥1,000 per share. To price the ADR around $30, the bank might set a 4:1 ratio (one ADR represents 4 shares).

Dividends and ADRs

When the foreign company pays a dividend:

1. Dividend paid in foreign currency to depositary bank
2. Bank converts to U.S. dollars
3. Bank deducts fees and any foreign withholding taxes
4. Net dividend distributed to ADR holders in U.S. dollars

Foreign Tax Considerations

Many countries withhold taxes on dividends paid to foreign investors. ADR holders may be subject to:

• Foreign withholding tax - Deducted before U.S. dollar conversion
• U.S. taxes - Dividends are also taxable in the U.S.
• Foreign tax credit - U.S. investors may claim a credit for taxes paid to foreign governments

Important: The tax implications can be complex. ADR investors should be aware they may face double taxation without proper tax planning.

Risks Specific to ADRs

While ADRs simplify foreign investing, they carry unique risks:

Currency Risk

Although ADRs trade in dollars, the underlying shares are valued in foreign currency. Currency fluctuations affect ADR value:

• If foreign currency strengthens vs. USD → ADR value increases
• If foreign currency weakens vs. USD → ADR value decreases

Political Risk

Investing in foreign companies exposes investors to political instability, nationalization, or adverse policy changes in the foreign country.

Economic Risk

Foreign economic conditions—inflation, recession, monetary policy—directly affect the underlying company and ADR value.

Information Risk

Despite SEC requirements, information about foreign companies may be:

• Less detailed than U.S. company disclosures
• Based on different accounting standards
• Less timely due to time zones and translation

Liquidity Risk

Some ADRs, especially Level I trading on OTC markets, may have lower trading volume than comparable U.S. stocks.

ADRs on the SIE Exam

Key points to remember:

• ADRs trade in U.S. dollars on U.S. exchanges
• ADRs are issued by U.S. depositary banks
• Level I ADRs trade OTC only
• Level III ADRs can raise new capital
• ADR holders face currency risk even though they trade in dollars
• Dividends are paid in U.S. dollars after conversion and tax withholding

Key Takeaways

• ADRs let U.S. investors easily invest in foreign companies
• Depositary banks hold foreign shares and issue ADRs representing them
• Three levels of ADRs offer different trading venues and reporting requirements
• ADR ratios adjust foreign share prices to appropriate U.S. trading ranges
• Currency risk is the primary unique risk for ADR investors
• Dividends are converted to U.S. dollars with potential foreign tax withholding