American Depository Receipts (ADRs): Full Form, Types, Advantages and Disadvantages

What are American Depository Receipts (ADRs)?

American Depositary Receipts (ADRs) are securities issued by banks in the United States. ADRs serve as negotiable securities and indicate ownership in the equity of foreign corporations. These financial instruments are designated in United States dollars, are traded on prominent United States stock exchanges such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ), and are subject to regulation by United States securities regulations. The full form of ADR is American Depositary Receipts.

American Depositary Receipts (ADRs) provide US investors with a way to get investment exposure to non-US firms without engaging in foreign stock markets. They represent some of the most well-known names in the global industry, including Nokia, Royal Dutch Petroleum, and Unilever. These and many other companies with headquarters outside of the US use ADRs for trading their shares in US markets.

How do ADRs Work?

American Depositary Receipts (ADRs) are helpful instruments for Individuals in the United States who wish to invest in overseas companies but are concerned about complying with foreign exchange regulations. Imagine you want to invest in a faraway company but you have no idea how to do the necessary financial due diligence or how to acquire stock in the firm. ADRs help in this scenario. A giant American financial institution partners with an overseas company and promises: “We’ll take care of all the confusing stuff.” Shares of that foreign firm are purchased in order to create American Depositary Receipts (ADRs), which may then be traded on the New York Stock Exchange. You will receive a portion of the company’s earnings through your financial institution if the business is profitable. It’s a less complicated approach to investing in foreign businesses, although expenses may be associated.

The formal process of how ADR works is as follows:

1. Issuer Selection

A foreign company interested in accessing U.S. capital markets through ADRs selects a U.S. bank or financial institution to act as a depository bank. The depository bank serves an important role in issuing and managing the ADRs.

2. ADR Creation

In the foreign market, the depository bank purchases a specified number of shares of the foreign company’s stock. The custodian of the depository bank in the foreign country holds these shares. The depository bank then issues ADRs in the United States, with each ADR reflecting a certain number of shares of the foreign company’s stock.

3. Level of ADRs

There are various categories of ADRs, which indicate the extent of cooperation between the foreign company and the depository bank:

• Level 1 ADRs are typically used by companies that have no intention of raising capital on the U.S. market. They have minimal reporting requirements and provide investors in the United States with rudimentary access.
• Level 2 ADRs require more detailed reporting and disclosure to the Securities and Exchange Commission (SEC) in the United States. Companies that issue Level 2 ADRs frequently utilize them to raise financing in the US market.
• Level 3 ADRs necessitate even stricter reporting requirements and are typically used by companies actively raising capital in the U.S. market.

4. Trading on U.S. Exchanges

ADRs are listed and transacted on U.S. stock exchanges, such as the New York Stock Exchange (NYSE) and the NASDAQ, once they are issued. ADRs can be purchased and sold by U.S. investors in a similar manner as any other U.S.-listed stock.

5. Dividends and Benefits

The foreign company pays dividends to the depository bank, which then converts them into U.S. dollars and distributes them to ADR holders. Also, ADR holders may also receive other corporate actions, such as rights offerings and stock splits, if the depository bank facilitates them. 

6. Voting Rights

American Depositary Receipts (ADRs) typically confer certain privileges to ADR holders, such as the right to participate in crucial decision-making processes through exercising voting rights in the foreign company’s shareholder meetings. The specific rights to vote are contingent upon the provisions outlined in the ADR program and the level of ADR.

7. ADR Fees and Costs

ADRs incur various fees and expenses, such as issuance fees, custody fees, and currency conversion fees. These costs are typically incurred by the ADR holders and might have an impact on their overall returns.

8. ADR Cancellation

ADR cancellation is a situation in which investors may elect to exchange their ADRs for the underlying foreign shares. Typically, this is done when investors want to hold shares directly on a foreign market.

Types of ADRs

There are two types of ADRs:

1. Sponsored ADRs

A sponsored American depositary receipt (ADR) is a depositary receipt (ADR) issued by a bank on behalf of a foreign company whose equity functions as the underlying asset. A sponsored ADR establishes a legal relationship between the ADR and the foreign company, which bears the cost of the security’s issuance. Sponsored ADRs can be listed on prominent exchanges, whereas unsponsored ADRs can only trade on the over-the-counter market (OTC).

2. Unsponsored ADRs:

A depositary bank initiates an unsponsored ADR program without the company’s contractual involvement. The establishment of an unsponsored ADR program is prompted by demand from brokers and investors. In the United States, ADRs are transacted on the over-the-counter (OTC) market.

Advantages of ADRs

1. Access to Larger Investor Base: ADRs enable foreign companies to gain access to a larger international investor base, particularly in the United States, without the complexities of listing on multiple foreign exchanges. ADRs are listed and transacted on the U.S. stock exchange, which frequently has greater trading volumes and liquidity than foreign markets. This can attract additional investors and increase the liquidity of the company’s shares.

2. Diversification: ADRs permit investors to diversify their portfolios by investing in companies from various countries and industries, thereby mitigating risk.

3. Increased Investor Interest: ADR listings enhance the visibility and recognition of foreign companies on the global market, potentially resulting in increased investor interest and positive branding.

4. Additional Shares Issues: Sponsored ADRs, particularly Level 2 and Level 3, enable foreign companies to issue additional shares to investors and raise capital on the U.S. market.

5. Avoids Currency Conversion Hassles and Risk Associated with them: ADRs trade like regular stocks on U.S. exchanges, making it convenient for U.S. investors to buy and sell shares without navigating foreign market rules and currency conversions. Also, Dividends paid by the foreign company to the depository bank are converted into U.S. dollars and distributed to ADR holders, which simplifies the process of receiving dividend payments. ADRs provide investors with exposure to the equities of foreign companies without requiring them to deal directly with foreign currencies, thereby mitigating currency exchange rate risks.

To sum up, ADRs provide a variety of benefits to both foreign companies and U.S. investors, including increased market access and opportunities for capital financing, simplified trading, and exposure to global investments.

Disadvantages of ADRs

1. Longer Waiting Time Returns: ADRs, like any other investment, may need a considerable amount of time to earn profits. Nevertheless, the timeframe for producing profits is not exclusively controlled by the classification of the investment as an American Depositary Receipt (ADR). The determinants of stock prices are multifaceted, encompassing the financial performance of the underlying firm, prevailing market circumstances, and broader economic issues. While many American Depositary Receipts (ADRs) may require a longer period to earn returns, others may see more rapid appreciation.

2. Fluctuations in Foreign Exchange Market: The volatility of foreign exchange rates is a valid area of concern. American Depositary Receipts (ADRs) are designated in the currency of the United States, namely the U.S. dollar, despite their underlying purpose of representing ownership in a foreign corporation. Consequently, variations in the exchange rate between the United States dollar and the currency of the domicile nation of the firm might have an effect on the valuation of one’s investment. The presence of these changes might potentially contribute to increased levels of risk and uncertainty within your investment.

3. Lesser Alternatives for Investment: Although it is accurate to acknowledge that not all foreign companies provide American Depositary Receipts (ADRs), there are only a few selections of ADRs accessible for investing purposes. Various internationally recognized companies have American Depositary Receipts (ADRs) listed on United States stock exchanges, therefore offering investors the opportunity to engage with a wide array of sectors and marketplaces. Nevertheless, it should also be noted that not all international companies can be accessed via American Depositary Receipts (ADRs).

When considering any investment, including American Depositary Receipts (ADRs), it is essential to conduct exhaustive research, assess one’s risk tolerance, and consider one’s investing objectives. If one is concerned about the previously mentioned disadvantages, it would be sensible to diversify their investment portfolio by including a variety of investment options, thereby reducing the associated risks. A consultation with a financial advisor might provide specialised insights tailored to your specific needs and goals.