Most international investors are familiar with American Depositary Receipts (ADRs) that make it easy to purchase foreign companies on U.S. stock exchanges. But there are several other types of depositary receipts that investors may come across.
What Are Depositary Receipts?
Depositary receipts are simply financial instruments trading on a local exchange that represent a foreign company’s publicly-traded securities.
Depositary receipts are issued by investment banks in a process that involves purchasing shares in a foreign company, grouping them into packets (usually 10 shares per packet), and issuing each packet as a depositary receipt on a local stock exchange. The shares issued on the stock exchange are priced in local currency and pay dividends in the local currency, which simplifies that process for domestic investors looking to buy shares in foreign stock.
The prices of depositary receipts are based on the value of the underlying shares, but they are independently traded and settled. For example, Roche Holdings Ltd. (ROG) on the SIX Swiss Exchange won’t have the same valuation as Roche Holdings Ltd. (RHHBY) ADR. Traders may even find arbitrage opportunities between the shares where they can simultaneously buy a foreign stock and sell an ADR for a marginal profit.
Types of Depositary Receipts
Depositary receipts work the same regardless of their region with the exception of the stock exchange and underlying currency. That said, there are different terms used by investors for depositary receipts in different regions, that are important to know.
American Depositary Receipts (ADRs) may be the most familiar to U.S. international investors. An ADR represents a set number of shares of foreign stock and trades on U.S. stock exchanges, such as the New York Stock Exchange (NYSE) or NASDAQ.
European Depositary Receipts (EDRs) provide European investors with locally-traded shares in non-European companies. While EDRs may be issued in any European currency, the most common currency is the euro, since it’s the most widely used in the region.
Global Depositary Receipts (GDRs) are the generalized form of an ADR or EDR. In other words, they represent non-American and non-European depositary receipts. They are most commonly used by developed markets to invest in frontier or emerging markets.
Depositary Receipt Trading
The most popular issuers of GDRs include J.P. Morgan, Citigroup, Deutsche Bank, and the Bank of New York Mellon, but there are countless banks that issue these kinds of securities around the world. These banks generate revenue when the ADRs are sold into the market by charging a commission on the trade—just like any other trade. Banks may also charge fees on dividends issued and pass on any expenses related to currency conversions.
ADRs are listed on stock exchanges like the Frankfurt Stock Exchange, Luxembourg Stock Exchange, and the London Stock Exchange. At these exchanges, ADRs trade on the International Order Book—or IOB—that serves as an electronic order book for international securities.
Investors trading ADRs, EDRs, or GDRs should also be aware of several unique risk factors that could influence their profitability:
- Currency Risk: Depositary Receipts must be converted into the home currency at some point, which means that currency dynamics can make a big difference in pricing and dividend yields. Investors should keep these factors in mind.
- Political Risk: Depositary Receipts represent ownership in international shares, which means that they may be subject to international risk factors, such as political risks, especially because they typically target emerging markets.
- Liquidity Risk: Depositary Receipts may not trade as frequently as the foreign stock, which means that investors could have a hard time buying or selling at a fair price, particularly when a market is moving sharply lower.
The Bottom Line
Most international investors are familiar with American Depositary Receipts (ADRs) that make it easy to purchase foreign companies on U.S. stock exchanges. But there are several other types of depositary receipts that investors may come across, including European Depositary Receipts (EDRs) and Global Depositary Receipts (GDRs). It’s important for international investors to understand these terms to fully understand the best ways to buy and sell shares, as well as the unique risk factors that may be involved in the process.