Risks associated with Trade of American Depositary Receipts

An American Depository Receipt (ADR) is a negotiable certificate comparable and trades in a similar manner to a common stock. A U.S. bank issues ADRs although it represents the shares of a non-U.S. publicly traded company. In other words, ADRs are foreign shares deposited in a US bank. ADRs are denominated in U.S. dollars and the dividends are also paid in the same currency. The custodianship of the shares associated with the ADRs remains with a U.S. bank in the company’s home country. However, the terms of its custodianship would be determined by the terms mentioned in the ADR certificate itself.

Why use American Depository Receipts?

ADRs are a method to acquire stocks traded in a foreign exchange, which is somewhat similar to buying shares in a foreign exchange. However, when buying shares from a foreign exchange, either directly or through a broker, there can be few disadvantages. Among them, the use of local currency, the need to have access to the foreign exchange, issues of international trade, global custody, foreign brokerage fees, losses in currency conversion and the necessity to undertake multi-currency accounting are some of the most notable. Therefore, buying shares directly or through a broker from a foreign exchange is considered a cumbersome and a costly method. ADR however, will be immune to such issues and could be more profitable to the investor.

Risks and disadvantages of ADRs

However, ADRs are not without risks or disadvantages when compared to other types of investment instruments. First of all, ADRs are known to lack in diversification. The reason being that only a proportion of foreign companies offer ADRs. Furthermore, in most instances these companies are the larger companies, which are renowned all over the world. Thus, as pointed out by investment experts, it could lead to a under diversification of the international portion of an overall investment portfolio when the ADRs are the only foreign holdings.

Secondly, the ADRs will always be subjected to foreign market risks. These risks would include possible losses due to foreign currency translation, being influenced by the political stability of the company’s home country, the ADR value not being representative of the value of the underlying common shares in its overseas market as well as the lack of investor protection and recourse. At the same time, the ADRs will also be subjected to market, country and company specific risks as well.

At the same time, in the event of a liquidation or winding-up of the company, the holders of its ADRs are not guaranteed of being able to enforce their right of claim and therefore they may lose their entire investment. In addition, the investors of ADRs may also have to deal with the risks associated with the parties involved with the whole investment process.

Thus, the decision to invest in ADRs should be taken after carefully considering the objectives of the investment, the risks associated with the whole process of investment and the methods available to minimize such risks through the investment banker.