Before we take a look at American Depositary Shares, we first need to understand the concept of American Depositary Receipts (ADR). The first ADR was introduced by J.P. Morgan back in 1927 for the British retailer, Selfridges. An ADR is a financial product that trades in the US financial markets but represents securities of a foreign company.
Essentially, ADRs make it easier for US investors to invest in foreign companies, as the complications of purchasing the shares in the company’s domestic markets are eliminated. The US custodian bank holds the economic and corporate rights of the shares, and the foreign company can opt to list its shares on major exchanges, such as Nasdaq, NYSE, or OTCC.
The entire issue of all the shares is called the ADR, whereas individual underlying shares are American Depositary Shares (ADS). ADS usually comes into play because securities law prevents most corporations listed in a foreign market to directly list on US exchanges. As foreign companies still want a way to sell shares in the US, they will create ADS.
How Do ADS Relate to Common Stock?
American Depositary Shares are essentially the same as common stocks in terms of rights. An investor is still getting ownership of the company and will still receive the same type of benefits, such as dividends. The ratio between ADS to common stocks is usually one to one, but in rare cases, it can be of a different proportion.
Benefits of ADR and ADS
For the Foreign Company
Expand geographic outreach: For the foreign company, the main purpose of creating ADR and ADS is to expand the geographical outreach of the company’s shares and allow investors from the United States to also invest in the business.
Another option for raising capital: They offer additional options for raising capital and currency.
Accommodates foreign company employees: They allow foreign employees of the company living in the U.S. to buy the stock.
For American Investors
Portfolio expansion: ADS allows them to expand their portfolio by investing in foreign companies.
Conversion: The dollar-based pricing system results in prices for ADS quoted in US dollars, and dividends are also paid for in US dollars.
Trading hours: ADS are traded during U.S. market hours, so it creates an ease of use for American investors.
Risks of ADS
For the Foreign Company
1. Foreign exchange risk
Foreign exchange risk is essentially the same risk as to the one we mentioned for investors, but we wanted to acknowledge that the foreign company also faces the other side of the risk.
2. Liquidity risk
Even though ADS expands a company’s shares into the US, there may be a liquidity risk depending on the appetite of investors for the company’s shares. If the appetite is low and there is a low volume of ADS bought, the foreign company may not be able to receive the capital raising it needed.
For American Investors
1. Country climate risk
First and foremost, investing in ADS will involve the same risk as actually investing in a foreign company. Investors will still face the risk of the country and the company, such as economics, politics, wars, etc.
2. Foreign exchange risk
In addition, you will face the risk of foreign exchange. Depending on how the US dollar compares to the foreign currency, the returns you earn from stock price changes and dividends may vary. For example, if the US dollar is up against the foreign currency, then the actual dollar amount of the dividend will go down. If the US dollar is down, the dividend dollar amount will increase.
3. Tax treatment risk
There can also be tax treatment differences between countries that will affect the return. For example, some companies apply a withholding amount on cash flows issued for ADS. Since the withholding amount can change depending on the country, some investors may get taxed more for their returns.
4. Small amount of choices
Although ADS is an easy way to transfer a foreign company’s shares into the U.S., not all companies do it. For example, Japan’s Toyota issues ADS, whereas Germany’s BMW does not. It results in a limited selection for investors, as some companies may be unavailable to invest in.
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