Quick Answer
An ADR is a U.S.-dollar certificate, issued by a U.S. depositary bank, that represents shares of a foreign company held by an overseas custodian. ADRs trade on U.S. markets like domestic stocks. Sponsored ADRs carry greater SEC reporting than unsponsored ADRs, and no ADR eliminates currency risk.
Moving from equity derivatives to international equity, ADRs are the primary vehicle U.S. investors use to access foreign stocks without dealing with foreign exchanges.
What Is the Structure and Purpose of an ADR?
- An ADR is a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares in a foreign company
- ADRs allow U.S. investors to buy foreign stocks that trade on U.S. markets and are denominated in U.S. dollars
- The actual foreign shares are held by a custodian bank in the company's home country
- One ADR may represent one share, a fraction of a share, or multiple shares of the foreign stock (the ADR ratio)
- An ADR that already has a pre-existing market outside the U.S. is not treated as a "new issue," so the IPO restricted-persons purchase limits do not apply to it
How it works:
- Foreign company's shares are deposited with a custodian bank overseas
- A U.S. depositary bank issues ADR certificates against those shares
- ADRs trade on U.S. markets just like domestic stocks
- Investors buy and sell ADRs in U.S. dollars through their regular brokerage accounts
What's the Difference Between Sponsored and Unsponsored ADRs?
| Feature | Sponsored ADR | Unsponsored ADR |
|---|---|---|
| Issuer involvement | Foreign company enters agreement with a U.S. depositary bank | Created by a depositary bank without the company's participation |
| SEC reporting | Subject to SEC reporting requirements (varies by program) | Minimal SEC reporting; financial disclosures may not be translated |
| Where traded | OTC or U.S. exchanges | OTC markets only |
| Transparency | Higher disclosure and investor protections | Less transparency |
| Voting rights | Typically passed through to ADR holders | Usually not passed through |
Exam Tip: Gotchas
- Unsponsored ADRs trade OTC only and have minimal SEC oversight. If a question describes an ADR with no company involvement and limited disclosures, it is unsponsored.
What Risks Do ADRs Carry?
Even though ADRs simplify foreign investing, they carry unique risks.
- Currency (exchange rate) risk: The underlying value fluctuates with the exchange rate between the U.S. dollar and the foreign currency, even though ADRs trade in U.S. dollars
- Political risk: Changes in the foreign country's government, regulations, or stability can affect the investment
- Inflationary risk: Inflation differentials between the U.S. and the foreign country affect real returns
Think of it this way: ADRs simplify foreign investing by letting you trade in dollars on U.S. exchanges. But the underlying shares are still priced in a foreign currency. If that currency drops against the dollar, your ADR loses value even if the foreign stock price stays flat.
Exam Tip: Gotchas
- ADRs do NOT eliminate currency risk. They remove the need for foreign exchanges, brokers, and settlement systems, but exchange rate fluctuations still affect the ADR's value.
- A weaker home currency cuts the dollar value even when the foreign shares never move. A British company's shares hold steady at 80 pounds. At $1.30 per pound they convert to $104. If the pound weakens to $1.20, the same 80 pounds convert to only $96.
How Are ADR Dividends Paid?
- Dividends are declared in the foreign currency by the foreign company
- The depositary bank converts the dividend to U.S. dollars before paying ADR holders
- The investor bears the currency conversion risk: if the U.S. dollar strengthens against the foreign currency at conversion time, the dividend translates into fewer U.S. dollars
- ADR holders may be subject to foreign tax withholding on dividends
- Foreign taxes withheld may be eligible for a U.S. foreign tax credit (to avoid double taxation)
Exam Tip: Gotchas
- Foreign tax withholding on ADR dividends may qualify for a U.S. foreign tax credit. The investor does not simply lose the withheld amount; the credit helps avoid double taxation.
What Rights Do ADR Holders Have?
- ADR holders generally have the right to receive dividends (converted to U.S. dollars)
- Voting rights depend on the terms of the depositary agreement:
- Sponsored ADRs typically pass through voting rights
- Unsponsored ADRs usually do not pass through voting rights
- ADR holders can sell their ADRs on the U.S. market at any time during trading hours
What Should You Check on Exam Day?
- Confirm currency risk survives every ADR structure, sponsored or unsponsored
- Trace voting rights back to the depositary agreement: sponsored usually passes them through, unsponsored usually does not
- Remember foreign tax withheld on ADR dividends can qualify for a U.S. foreign tax credit, not a total loss