Most international investors have heard about American depositary receipts (ADRs), which make it easy to purchase stocks of foreign companies on U.S. stock exchanges, but how can you make purchases in other markets? ADRs may be the home base for investors in the U.S., but they are just one type among many that are used in other countries and markets.
If you trade on the international market, there are many other types of depositary receipts that you may come across. Learning the basics can help you open the doors to global trading.
What Are Depositary Receipts?
Depositary receipts are simply financial instruments, traded on a local exchange, that stand for the publicly traded securities of a foreign company. They allow you to buy and sell shares of stock in companies based in other countries, from within a market or exchange in your home country.
Depositary receipts are issued by firms or banks in a very simple process. First they purchase shares in a foreign company. These shares are then grouped into packets (most often with 10 shares per packet). Once grouped, they issue 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, making the process simple for domestic investors who are looking to buy shares of foreign stocks.
The prices of depositary receipts are based on the values 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 the Roche Holdings Ltd. (RHHBY) ADR.
If you are a savvy trader, you may even be able to find arbitrage opportunities between the shares where you can buy a foreign stock and sell an ADR for a marginal profit at the same time.
Types of Depositary Receipts
Depositary receipts work the same, no matter what region they are from, except for the stock exchange and underlying currency. You should know the precise terms used for depositary receipts in different regions.
American Depositary Receipts (ADRs)
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)
EDRs provide European investors with locally traded shares in non-European companies. While EDRs may be issued in any European currency, the most common is the euro, since it’s the most widely used in the region.
Global Depositary Receipts (GDRs)
GDRs are the generalized form of ADRs or EDRs. In other words, they stand for both non-American and non-European depositary receipts. They are most often used in 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 they may pass on any costs that relate 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 (IOB), which serves as an electronic order book for international securities.
If you trade ADRs, EDRs, or GDRs, you should also be aware of the unique risk factors that could have an effect on profits.
- Currency Risk: At some point, you'll have to convert depositary receipts into your home currency. That means you should keep in mind that currency dynamics can have a major effect on pricing and dividends.
- Political Risk: If you purchase depositary receipts, you own international shares. They may be subject to risk factors of other countries, such as political risks. You should be extra-cautious with this type of risk if you target emerging markets.
- Liquidity Risk: Depositary receipts might not trade as much as the foreign stock, which means that you could have a hard time buying or selling the at a fair price, particularly when a market is moving sharply lower.
The Bottom Line
If you plan to invest in international markets, ADRs are just the start, as EDRs and GDRs may have a place in your investing as well. If you purchase foreign stocks on foreign markets, it's important to get familiar with these terms so you will understand the best ways to buy and sell shares, as well as the unique risk factors that may be involved in the process.