ADRs

So guys till today I wrote about invest/trading in our own country’s markets. Investing in our country's stock market is relatively simple (I am not talking about present conditions). But investing in a company that is listed on a foreign exchange is much more difficult.

However, now there is an easy way around this through American Depositary Receipts (ADRs). More than 2000 foreign companies provide this option for U.S. and Canadian investors interested in buying shares.

What is ADR?

Introduced to the financial markets in 1927, an American depositary receipt (ADR) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage.

ADRs were introduced as a result of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the shares into groups, and reissues them on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) or the NASDAQ. In return, the foreign company must provide detailed financial information to the sponsor bank.

ADR Pricing

The depositary bank sets the ratio of U.S. ADRs per home-country share. This ratio can be anything less than or greater than 1. This is done because the banks wish to price an ADR high enough to show substantial value, yet low enough to make it affordable for individual investors. Most investors try to avoid investing in penny stocks, and many would shy away from a company trading for 50 Russian roubles per share, which equates to US$1.50 per share. As a result, the majority of ADRs range between $10 and $100 per share. If, in the home country, the shares were worth considerably less, then each ADR would represent several real shares.

Confused, let me take hypothetical example. As usual I will take my favorite stock BHEL for calculation. Now assume

• BHEL is trading at Rs. 1600 (I know its today’s closing price is 1790, but for simple calculation purpose I am taking that.)
• Exchange rate is Rs. 40 = $ 1 (Again today’s exchange rate is Rs. 44.25 = $ 1)

Let's say that a U.S. bank purchases 50 Lakh shares from BHEL and issues them in the U.S. at a ratio of 10:1. This means each ADR share you purchase is worth 10 shares on the Indian Stock Exchange. A quick calculation tells that the new ADR should have an issue price of around US $400 each (10 times $40).

Once an ADR is priced and sold on the market, its price is determined by supply and demand, just like an ordinary stock. However, if the U.S. price varies too far from the Indian price after taking the currency exchange rate and the ratio of ADRs to home country shares into account, an arbitrage opportunity may arise. ADRs tend to follow the general trend of the home country shares, but this is not always the case.

Types of ADRs

There are three different types of ADR issues:

• Level 1 - This is the most basic type of ADR where foreign companies either don't qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs are found on the over-the-counter market and are an easy and inexpensive way to gauge interest for its securities in North America. Level 1 ADRs also have the loosest requirements from the Securities and Exchange Commission (SEC).

• Level 2 - This type of ADR is listed on an exchange or quoted on NASDAQ. Level 2 ADRs have slightly more requirements from the SEC, but they also get higher visibility trading volume.

• Level 3 - The most prestigious of the three, this is when an issuer floats a public offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in the U.S. financial markets.

Risks

• Political Risk - Ask yourself whether you think the government in the home country of the ADR is stable? For example, you might be wary of BHEL because of the stability in the Indian government.
• Exchange Rate Risk - Is the currency of the home country stable? Remember the ADR shares track the shares in the home country. If a country's currency is devalued, it will trickle down to your ADR. This can result in a big loss, even if the company had been performing well.
• Inflationary Risk - This is an extension of the exchange rate risk. Inflation can be a big blow to business because the currency of a country with high inflation becomes less and less valuable each day. Like our present condition.

Source… Investopedia…

Keep reading…

Keep investing (Abroad also… ha ha…)

Regards

Naveen C.M.