An American Depositary Receipt (ADR) is a negotiable instrument issued by a U.S. depositary bank (e.g., Citibank, J.P. Morgan, Deutsche Bank) that represents ownership in a specific number of shares of a foreign company's stock. The underlying shares (ordinary shares) are held by the depositary bank's custodian in the company's home country. ADRs trade on U.S. exchanges (NYSE, NASDAQ) or OTC in U.S. dollars, allowing American investors to invest in foreign companies without the complexities of foreign market transactions.
ADR ratios vary: one ADR may represent 1, 5, 10, or a fraction of the underlying foreign shares, depending on how the issuer structures the program. ADR prices reflect the underlying share price adjusted for the ratio and current exchange rates.
ADR holders receive dividends in U.S. dollars (converted from the foreign currency by the depositary bank), and may be subject to foreign withholding taxes on those dividends. U.S. investors can claim a foreign tax credit on their U.S. return to offset this withholding. Dividends received may qualify for the qualified dividend rate if the company is from a country with a U.S. tax treaty.
Risks include currency risk (exchange rate fluctuations affect ADR value), political risk, country risk, information risk (foreign companies may have different disclosure standards), and liquidity risk for thinly traded ADRs. Unsponsored ADRs are created by depositary banks without the company's participation; sponsored ADRs involve a formal agreement with the issuing company and are more common on major exchanges.
> Exam tip: On the Series 7 and Series 65/66, know that ADRs allow U.S. investors to gain foreign equity exposure through U.S. markets. Understand that ADRs trade in USD but carry currency risk because the underlying assets are priced in a foreign currency. Know the difference between sponsored (company participates) and unsponsored ADRs.