1.5 ADRs and Foreign Securities

What Are ADRs?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank that represents shares of a foreign company held in custody abroad. ADRs trade on U.S. markets in U.S. dollars, settle on the same T+1 cycle as domestic stocks, and let U.S. clients gain international exposure without dealing in foreign currencies or markets.

How an ADR Is Created

1. A U.S. depositary bank acquires shares of the foreign company.
2. A custodian bank in the issuer's home country holds the underlying shares.
3. The depositary bank issues ADRs against those deposited shares.
4. The ADRs trade on U.S. exchanges or OTC like ordinary stock.

ADR ratio: one ADR may equal one, several, or a fraction of a foreign share. A 10:1 ratio means 10 ADRs represent 1 foreign share; the ratio is set so the ADR trades in a price range familiar to U.S. investors.

ADR holders generally receive dividends and may receive pass-through voting (on sponsored programs), but they hold a receipt, not the registered foreign share itself.

Sponsored vs. Unsponsored

Sponsored ADRs are preferred because the foreign issuer cooperates, producing better disclosure, services, and voting. Unsponsored ADRs are bank-created without issuer involvement, can be duplicative across banks, and provide thin shareholder rights.

The Three ADR Levels

Sponsored ADRs fall into three levels by registration and trading privileges.

Level I

Level I is the cheapest, simplest way for a foreign firm to establish a U.S. trading presence.

Level II

Level II buys exchange visibility and liquidity but still cannot raise new capital.

Level III

Level III carries the heaviest compliance burden but is the only level that can raise capital in U.S. markets.

Currency Risk

Currency (exchange-rate) risk is the distinctive ADR risk. The ADR prices in dollars, but the underlying share is valued in the home currency, so the holder is exposed to both company performance and FX moves.

• Foreign currency strengthens vs. USD → ADR value rises.
• Foreign currency weakens vs. USD → ADR value falls.

If a German firm's stock is flat in euros but the euro gains 5% against the dollar, the ADR rises roughly 5% in dollar terms even with no change in the business.

Dividends and Taxation

Conversion: the foreign issuer pays dividends in local currency; the depositary bank converts them to dollars before distribution, and conversion fees can trim the amount received.

Foreign withholding: many countries withhold tax on dividends paid abroad, raising the threat of double taxation. U.S. investors may claim a foreign tax credit on their U.S. return to offset the foreign tax withheld, capped at the U.S. tax otherwise due on that foreign income.

Tax treaties: U.S. treaties cut withholding for many countries — the U.S.–U.K. treaty, for instance, can lower withholding from 30% to 15%.

Rights of ADR Holders vs. Ordinary Shareholders

ADR holders are not the registered owners of the foreign shares; the depositary bank is. As a result, ADR holders typically cannot attend the foreign company's shareholder meeting in person. On a sponsored program the depositary passes voting materials through and votes per the holder's instruction, but on unsponsored programs voting is usually unavailable. ADR holders also generally do not receive preemptive rights directly; if the foreign issuer conducts a rights offering, the depositary may sell the rights and distribute cash instead.

The exam tests that ADRs deliver economic exposure and dividends but a thinner bundle of governance rights than holding the ordinary share abroad.

Cancellation and Arbitrage

An ADR can be cancelled: the holder instructs the depositary to cancel the receipt and deliver the underlying foreign shares, which can then trade in the home market. This convertibility keeps the ADR price tied to the underlying share value (adjusted for the ratio and exchange rate); when the prices diverge, arbitrageurs create or cancel ADRs until parity is restored. You do not need to compute the arbitrage, but you should know the linkage exists and that it constrains how far an ADR price can drift from its underlying.

Suitability Considerations

ADRs suit clients who want international diversification with U.S.-market convenience and can accept currency and political risk. They are not a substitute for a guaranteed-income product, and concentrating in a single-country ADR adds sovereign risk. A representative recommending ADRs should disclose that returns combine business performance and FX moves, and that thinly traded (often Level I, OTC) ADRs carry liquidity risk that can widen spreads at sale.

Benefits and Risks

Exam Focus

• Match each level to its venue, registration, and capital-raising ability — only Level III raises capital.
• Sponsored (issuer-backed, voting pass-through) vs. unsponsored (bank-created, OTC).
• Currency risk direction: stronger foreign currency lifts the ADR; weaker drags it.
• Foreign tax credit and treaty relief for withheld dividends.