A Basic Explanation of ADRs
I have had several questions about ADRs (American Depository Receipts), receipts that trade here in the U.S. that represent participation in foreign shares.
ADRs are created a little differently depending on the country and its security regulations, but the idea is basically the same (I strongly encourage you to understand the details of any particular issue in entering into any transaction).
If a company in Britain wants (there is demand for) its shares to trade in the U.S. as well as in its local market, the company will issue shares into a trust (the largest custodian of ADRs is the Bank of New York) and the trust will pay for the shares in pounds at the current local price. The trust will then sell the shares out to U.S. buyers in dollars. Because U.S. buyers pay for the shares in dollars they have the misperception that they have no currency risk, but if you look at the structure of the transaction you will see that this is false; there is currency risk.
The trust itself runs the currency hedge: since it takes in dollars and pays out pounds to facilitate the buyers and sellers of the shares, it enters into the currency market to sell dollars and buy pounds. It can be safely assumed that the trust is not there to take currency risk, so when their currency hedge loses money (the pound goes down versus the dollar), they must reduce the price of the ADR commensurately to reflect that change since they must buy back the ADRs at the current price in local (pound) terms when the U.S. investors want sell their shares.
For example, if the ADR shares are issued one for one with the local shares and the dollar/pound is 1, then the ADR price will equal the local share price, let's say 100. If the local share price remains at 100 but the pound drops to .90 against the dollar, the ADR price will drop to $90 to reflect the drop in the pound.
This is the basic idea, but again there are numerous variations to this. For example, in certain countries there are restrictions in selling short local shares, so the ADRs can trade at a discount to fair value as short sellers depress their price relative to the local shares. Conversely, there are certain companies like Taiwan Semiconductor (TSM) whose ADRs trade at a premium because the company restricts the issuance of its local shares into ADRs significantly below the demand for them. Again, I encourage you when interested in a particular ADR to research the details.
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