What is the American Depository Receipt?
Investors worldwide scout for companies and their stocks that can give them good returns to achieve their financial goals. With the advent of digital technologies, investing in the stock market has gone beyond geographical barriers. Now, if you are an investor, you can look towards investing in foreign stocks.
For example, if you are a citizen of India, you can invest in the stocks of Apple or Google, using the same process as you do to buy Indian stocks. This process has allowed investors to have international exposure and invest in global companies that are one of the biggest in the world. Furthermore, the main idea behind investing in foreign stocks is the hedging factor. As the international market does not get affected by a local market, it allows investors to be profitable even if their local stock market is going through a downtrend.
Investors in the United States leverage this technique of investing in foreign stocks through a financial instrument called American Depository Receipt (ADR). This blog will help you understand what an American Depository Receipt is and how US citizens use it to hedge against their local investments and get international exposure along the way. But first, let’s understand a little about shares and how you become a shareholder.
What are Shares?
A share indicates a unit of ownership of the particular company. If you buy the shares of a company, you become the owner of the company in the proportion of the percentage of the purchased shares. From the day you buy the shares, you are a shareholder and entitled to receive a portion of the profit of the company. This amount is called the dividend, and the company declares it as per its financial performance. The shareholders can sell these shares anytime they want to another investor who would then become the shareholder.
What is an American Depository Receipt (ADR)?
An American Depository Receipt (ADR) is a negotiable financial certificate that represents a specific number of shares and is issued by a U.S depository bank for US investors. A negotiable instrument is the one in which the terms are not final and can be negotiated by the two parties involved. This means that the price of the American Depository Receipt (ADR) is not final and can be adjusted by the buyers and the sellers before entering into a legal agreement.
Like any other shares listed on the U.S stock exchanges, investors can also trade the American Depository Receipt (ADR) using the same trading process. The main idea behind issuing the American Depository Receipt (ADR) is to give U.S investors a way to purchase stocks of overseas companies and have international exposure. It also benefits overseas companies as they can attract and raise capital without going through the listing process and listing their companies on the U.S stock market.
The American Depository Receipt (ADR)s also offers dividends to the investors if it is announced by overseas companies. Both the American Depository Receipts (ADRs) and their dividend amount are priced in U.S dollars, allowing the investors to avoid the hassle of dealing in foreign currencies.
How do American Depository Receipts (ADRs) work?
Previously, if any U.S citizen wanted to invest in the stocks of overseas companies, the only way was to open a Demat and trading account with a stockbroker registered in the respective foreign country. This came with numerous hassles and forced the investors to deal with converting foreign currencies into the local currency at every step. However, the American Depository Receipts (ADRs) allows the investors to avoid all these hassles.
The American Depository Receipts (ADRs) are priced and valued in U.S dollars, meaning that investors do not have to deal with any other currency and all the transactions happen using their local currency. A U.S. financial institution holds the underlying security, i.e. the stocks of the foreign companies in the U.S. It purchases the stocks on the respective company’s foreign exchange, where it is listed. Once the purchase is completed, the financial institution issues the American Depository Receipts (ADRs), which the investors can purchase from the U.S stock exchange.
The American Depository Receipts (ADRs) list on the NASDAQ or the New York Stock Exchange. However, they are always sold ‘over-the-counter’. It means that the American Depository Receipts (ADRs) are traded using the broker-dealer network and not a centralised exchange. This allows the certificate to be negotiable as the parties involved can adjust the price and terms using the broker as the mediator.
Types of American Depository Receipts (ADRs)
There are two types of American Depository Receipts (ADRs) that U.S investors can trade:
Sponsored American Depository Receipts (ADRs): A U.S bank or financial institution issues sponsored American Depository Receipts (ADRs) on behalf of an overseas company. Under the sponsored American Depository Receipts (ADRs), the U.S bank or the financial institutions get into a legal agreement with the overseas company to issue the ADR in the U.S market.
The overseas company covers the expense of issuing the ADR and retains control over the ADR after it is issued. The bank or the financial institution provides support to the overseas company in handling the legal obligations and transactions with the U.S investors. Sponsored American Depository Receipts (ADRs) are categorised by the level of compliance with the American accounting process and the Securities and Exchange Commission (SEC) regulations.
Unsponsored American Depository Receipts (ADRs): A U.S bank or financial institution also issues unsponsored American Depository Receipts (ADRs) that do not see an overseas company’s involvement. Under the unsponsored ADRs, the bank or the financial institution do not have the permission or the participation of any overseas company. In such a case, there can be numerous ADRs of a single overseas company trading on the U.S market, which may vary in their price, terms and dividend amount. However, there is only one ADR of an overseas company if the ADR is a sponsored one.
Levels of American Depository Receipts (ADRs)
There are three levels of American Depository Receipts (ADRs):
Level 1: This is the most basic type of ADR level in which either the overseas companies fail the eligibility to issue an ADR or do not want their ADRs listed on the U.S exchange. Level 1 American Depository Receipts (ADRs) are primarily used by overseas companies to mark their presence on the U.S market but not to raise capital from U.S investors.
Level 2: Similar to Level 1 ADRs, Level 2 ADRs can also be used by overseas companies to mark their trading presence but can’t be used to raise capital from U.S investors. The Level 2 ADRs have more obligations with the SEC than the Level 1 ADRs and are tightly regulated by the centralised institutions. These Level 2 ADRs also get a higher trading volume and visibility in the U.S market.
Level 3: These ADRs are considered to be the most valuable as overseas companies can use them to list their ADRs through a public offering on the U.S exchange. Overseas companies utilise Level 3 ADRs to mark their trading presence and raise capital from U.S investors.
Through American Depository Receipts (ADRs), a U.S investor can effectively invest and trade in the stocks of overseas companies. The process requires no extra dealings in foreign currencies and the safeguarding of investments through the regulations of the bank and the SEC. As they are negotiable, you can also ensure that the pricing and the terms are according to your preference.
Frequently Asked Questions Expand All
There are many ADRs of Indian companies such as Genpact Limited, HDFC Bank, ICICI Bank etc., that are traded on the U.S exchange.
The advantage is that American Depository Receipts (ADRs) allows U.S investors to invest in overseas companies’ stocks and have international exposure. However, the disadvantage is that there are limited investment options, and the investor may have to cover the cost of currency conversion.