Introduced for the first time in 1927, an American Depositary Receipt (ADR) refers to a certificate that represents one or more shares of a foreign stock (that trades in U.S. Market), and is issued by a U.S. bank. The foreign-based stock may be actively trading on any of the three major U.S. equity markets that include NYSE, Nasdaq or AMEX; and under the above instrument, the foreign share is under an overseas custody. A large number of investors can purchase ADRs from the broker or dealers authorized to deal in them; and there are multiple ways in which brokers can get ADRs for their clients – either they go for purchasing the already issued ADRs on a U.S. exchange, or they themselves create new ADRs. For the creation of an ADR, a U.S. based broker can purchase the shares in the issuer’s home market and then the deposits of those shares bought from the issuer’s market can be done in a bank operating in that market. The bank then issues ADRs, which represent those shares to the broker’s custodian or the broker-dealer; and subsequently, the ADRs can be applied to the client’s account.
It is to be understood that the new ADRs can be formed basis the availability of the shares, prevailing market conditions, and the pricing and market for the ADRs. In the ADR creation process by the broker, which is also an unsponsored ADR program, the foreign company does not have a direct involvement in the ADR creation. As opposed to this, foreign companies may initiate sponsored ADR programs for shares that are required to be made available to U.S. investors. The latter form of ADRs related sponsorship and introduction is quite common as foreign firms typically intend to generate ADRs to have entree in the American markets in a seamless manner.
Now why many investors keep a close watch on ADRs. That’s because, American Depositary Receipts on issuance, also help investors receive dividends in U.S. dollars, which is preferred by the domestic investors while they own shares of a foreign company. This also averts getting into the process of currency conversion. However, ADRs are associated with certain risks, such as those related to currencies. Primarily, dividends under the ADRs are declared and paid in native currency while the dividends distributed are in dollars; and the whole process involves net of conversion costs and foreign taxes to respective shareholders. Hence, a change in exchange rate with/ without fluctuations in the currency market impacts the value of dividends.
On the other hand, ADRs also provide some specific benefits. For many industries or many sectors, for example the telecommunications sector where the U.S. investment market puts a higher valuation or price/earnings ratio (P/E) and the company is listed in Australia, a lower P/E scenario in Australia might help in receiving a higher valuation for the shares. Then non-U.S. companies establishing an ADR program sometimes can get a higher stock price associated with the company and can even raise capital in the United States.
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