Depositary Receipt

Core Description

• A Depositary Receipt (DR) is a tradable certificate issued by a depositary bank, representing shares of a foreign company. It enables local-market access and settlement for investors seeking global equity exposure.
• DRs serve as a bridge, granting investors access to international equities while offering the convenience of domestic trading, settlement, and currency.
• Investors should consider both the advantages of local access and diversification, as well as the specific risks including currency fluctuations, program terms, fees, and information asymmetries.

Definition and Background

A Depositary Receipt (DR) is a negotiable instrument created by a depositary bank to represent ownership in shares of a foreign public corporation. The depositary bank holds the underlying securities on behalf of the DR holder, generally through a local custodian in the company's home country. DRs can be traded on local stock exchanges, allowing investors to access foreign firms without directly participating in cross-border trading.

Brief History and Evolution

The first DRs appeared in 1927 when J.P. Morgan introduced the American Depositary Receipt (ADR) for Selfridges, a British retailer. This allowed U.S. investors to purchase shares of non-U.S. companies on domestic exchanges. The concept expanded, leading to variants such as Global Depositary Receipts (GDRs), often listed in London or Luxembourg. During the 1980s and 1990s, legal frameworks developed, especially in the United States, to enhance transparency and establish different ADR tiers.

Types and Structures

The primary types of DRs are:

• American Depositary Receipts (ADRs): Designed for the U.S. market, these may be listed on exchanges (Level II & III) or traded over-the-counter (Level I).
• Global Depositary Receipts (GDRs): Tradable on exchanges outside the issuer’s home market, such as in London or Luxembourg.
• European Depositary Receipts (EDRs): Focused on European exchanges.

DR programs may be sponsored—established with the issuing company’s consent, offering enhanced investor protections—or unsponsored, which are created by banks without issuer agreement, often with reduced disclosure and voting rights.

Calculation Methods and Applications

DRs are valued and managed using simple but essential formulas and mechanisms. Understanding these calculations is important for effective risk assessment and portfolio management.

Core Calculation Formulas

DR Price Calculation

• Formula:
  DR Price ≈ (Underlying Share Price × DR Ratio × FX Rate) ± Fees
• Example:
  If 1 DR represents 2 shares, the underlying share price is USD 50, the currency exchange rate is 1.1, and fees are negligible:
  Parity Price = 2 × 50 × 1.1 = USD 110

Implied Underlying Share Price

• Implied Underlying = DR Price / (DR Ratio × FX Rate)

Dividend per DR

• Dividend per DR = (Underlying Dividend × DR Ratio × FX Rate) - Withholding Tax - Bank Fees

Corporate Action Adjustments

• For stock splits or rights issues, recalculate the DR ratio to maintain value equivalence.

Typical Applications

• Arbitrage:
  When a substantial price difference occurs between a DR and its underlying share, after accounting for conversion and FX, institutional participants may create or cancel DRs to exploit the discrepancy.
• Portfolio Diversification:
  Institutional investors use DRs to gain exposure to major foreign stocks within the framework of domestic regulations.
• Retail Market Access:
  Individual investors can access prominent international firms, such as purchasing ADRs of Toyota or BP on U.S. exchanges.

Trading, Settlement, and Fees

DRs trade like domestic equities, usually following the local exchange’s settlement cycles (for example, T+2). Depositary banks may charge service fees. Brokerage commissions, FX conversion costs, and withholding taxes may impact total return, especially for dividend payments.

Comparison, Advantages, and Common Misconceptions

A clear understanding of DRs in relation to other products enables informed decisions.

Advantages

• Local Trading, Global Exposure:
  Investors can trade foreign equities in their home currency, using familiar brokers and settlement systems.
• Streamlined Corporate Actions:
  The depositary manages dividends, splits, and rights issues, which helps reduce cross-border administrative friction.
• Consistent Research and Liquidity:
  Many DRs, especially those of large international firms, receive ongoing research coverage and feature active market participation.

Disadvantages

• Impact of Fees:
  Depositary, custody, and FX conversion fees may reduce net dividend income and capital gains.
• Potentially Limited Rights:
  Voting rights and participation in corporate actions can be restricted, especially with unsponsored DR programs.
• Risks in Currency and Trading:
  Exchange rate movements, time-zone mismatches, and local market closures may cause deviations from the underlying share price.

Contrasts with Other Investment Vehicles

Common Misconceptions

• DRs are the same as ordinary shares:
  While DRs offer economic exposure similar to ownership, some rights—such as direct voting—may be limited.
• DRs eliminate FX risk:
  Although dividends and transactions are in the local currency, the DR's value is linked to the exchange rate.
• All DRs display the same liquidity and safety:
  Liquidity and disclosure standards differ by DR program, sponsor, and issuer.

Practical Guide

Investing in Depositary Receipts may offer benefits when approached methodically and with a full understanding of their distinct mechanics.

Clarify Investment Objectives

Define your goal for using DRs:

• Are you seeking diversification or targeted international exposure?
• Do you require dividends in your home currency?
• Are you aiming for close alignment with the underlying stock, or adding global companies to your portfolio?

Select the Right Program

• Program Type:
  Choose among ADRs, GDRs, or other regional DRs based on your market, liquidity preferences, and disclosure requirements.
• Sponsorship Level:
  Sponsored DRs often provide improved investor protection, transparency, and information access.

Assess Liquidity and Costs

• Review average daily volumes, bid-ask spreads, and market-maker availability.
• Compare DR trading hours to those of the underlying market to manage potential overnight price risk.
• Consider all cost factors: depositary fees, custody charges, FX conversion costs, and potential withholding tax.

Order Execution and Settlement

• Use limit orders for DRs with lower liquidity to manage execution price.
• For larger positions, execute orders incrementally during market hours.

Monitor Parity and Arbitrage

• Regularly compare DR and underlying share price parity, factoring in FX rates and the DR ratio.
• Noticeable deviations may indicate arbitrage activity; always consider all related costs.

Case Study: BP ADRs Example

A U.S. investor is interested in BP's ordinary shares, which trade on the London Stock Exchange. Rather than open a U.K. account, the investor buys BP ADRs on the New York Stock Exchange. Each BP ADR equals six BP ordinary shares. If BP trades at GBP 5 and the GBP/USD rate is 1.30, then one ADR parity equals 6 × 5 × 1.3 = USD 39. If the ADR trades at USD 39.50, the small premium can reflect costs, FX timing, and supply-demand differences. Dividends are paid in USD by the depositary, net of relevant fees and tax. The investor can trade, settle, and monitor activity using a U.S. broker.
This is a hypothetical example for illustration only, and does not represent investment advice.

Understand All Risks

Always review the deposit agreement closely for specifics on fees, voting, conversion, and other rights or obligations. Stay informed of changes in program terms or emerging risks as communicated by the depositary.

Resources for Learning and Improvement

A well-rounded understanding of DRs can be developed by consulting a variety of regulatory, market, and academic resources.

Regulatory and Listing Rule Sources

• U.S. SEC Investor.gov ADR Overview:
  Provides explanations of ADR definitions, rights, and potential risks.
• London Stock Exchange GDR Pages:
  Offers details on rules, eligibility, and the trading of GDRs.
• Deposit Agreements (EDGAR):
  Consult official deposit agreements for program-specific legal details.

Depositary Bank Materials

• BNY Mellon DR University:
  In-depth guides on DR concepts, fee schedules, and handling of corporate actions.
• J.P. Morgan DR Insights:
  Market trends, program specifics, and educational content.
• Citi Depositary Receipt Services:
  Directories and investor-focused tools.

Exchange and Clearinghouse Documentation

• NYSE and Nasdaq ADR Lists
• Euroclear/Clearstream resources on DR settlement

Academic and Professional Training

• Peer-reviewed articles on DR arbitrage and cross-listing (for example, Journal of International Money and Finance).
• CFA Institute Curriculum:
  Coverage includes DR instruments, FX impact, and related investment strategies.
• Exchange and bank webinars/courses:
  Continuing education for finance professionals.

Market Data and Screening Tools

• Bloomberg (ADR/ADRU functions):
  Comprehensive DR data including ratios, conversions, and creation rates.
• Refinitiv Eikon, OTC Markets Directory:
  Program information and liquidity metrics for investors.

Broker and Practical Guides

• Many brokers provide educational materials and platform tutorials focused on DR trading and related actions.
• Practice by examining the official filings of a real ADR, noting ratios, FX implications, and dividend records.

FAQs

What is a Depositary Receipt?

A Depositary Receipt (DR) is a certificate from a depositary bank that represents shares in a foreign company, allowing those shares to be traded on a local exchange in the investor’s home currency.

How is a DR created and cancelled?

DRs are created when a broker delivers the underlying shares to a custodian in the issuer’s market, after which the depositary bank issues DRs. The process is reversed to cancel the DR, with the depositary releasing the underlying shares or their cash value.

What is the difference between ADRs and GDRs?

ADRs are Depositary Receipts listed in the United States for U.S. investors. GDRs are structured for trading on international exchanges, such as those in London or Luxembourg, targeting broader global investors.

Do DR holders receive dividends?

Yes. Dividends from the underlying company are paid out to DR holders by the depositary bank in the DR’s local trading currency, minus any applicable taxes and fees.

Can DR holders vote on company matters?

Voting rights vary with each DR program. Sponsored DRs may allow better access to voting, though the process and deadlines can limit participation.

Are DRs affected by currency risk?

Yes. The value and returns on DRs are influenced by exchange rate movements between the DR’s trading currency and the currency of the underlying shares.

What are common fees associated with DRs?

Fees may include depositary service charges, FX conversion spreads, custody fees, and, in some cases, charges upon conversion or cancellation.

How do I buy or sell DRs?

DRs are bought and sold like domestic shares through brokerage accounts that support DR trading.

Are DRs the same as directly owning foreign shares?

No. DRs confer beneficial ownership, but some rights and obligations may differ, especially in areas like voting and participation in certain corporate actions.

Conclusion

Depositary Receipts (DRs) provide investors with a way to access foreign companies through domestic markets, offering diversification and convenience while also involving specific risks such as fees, currency exposure, and program variations. Investors should assess their own objectives and risk tolerance, carefully evaluate the details of the chosen DR program, and utilize reliable resources for research and monitoring. By maintaining objectivity and awareness, investors can decide whether DRs are suitable for inclusion in a global investment portfolio.