Understanding American Depositary Receipts (ADRs) and Investing in Foreign Markets

American Depositary Receipts (ADRs), also referred to as American Depositary Shares (ADSs), serve as an essential gateway for U.S. investors to access shares of foreign companies without having to deal with the complexities of foreign exchanges, different languages, or multiple currencies. ADRs are denominated, traded, and settled in U.S. dollars, and any dividends paid are also distributed in dollars, making them especially convenient for American investors. This structure eliminates the need for investors to convert currencies or navigate foreign trading systems, as all transactions occur within the familiar infrastructure of the U.S. financial markets.

An ADR is a negotiable security issued by a U.S. bank that represents shares in a foreign corporation. The U.S. bank purchases shares of the foreign company and holds them in custody, issuing receipts to American investors that represent ownership in the underlying foreign stock. These receipts, the ADRs, are traded on U.S. stock exchanges or over-the-counter (OTC) markets, just like shares of U.S.-based companies. ADRs can be sponsored or unsponsored, with sponsored ADRs involving an agreement between the foreign company and the U.S. depositary bank, typically offering more transparency and investor services. A defining feature of ADRs is the flexibility in how many shares each ADR represents. Some ADRs reflect a one-to-one correspondence with the foreign stock, while others use a ratio system where one ADR might represent multiple foreign shares or just a fraction. This ratio, called the participation rate, is designed to make ADR pricing align more naturally with U.S. market norms. For instance, if the local share price of a foreign company is very low or very high, the ratio is adjusted so that the ADR trades within a more conventional range on U.S. exchanges. To illustrate, consider a Brazilian corporation whose shares trade at approximately 11 Brazilian reals (BRL) each, while the exchange rate is around 5.5 BRL per U.S. dollar. If one ADR represents five shares of the Brazilian company, that ADR might be priced near $10 in U.S. markets, reflecting both the underlying value and the currency conversion. Though you won’t be required to calculate these exchange mechanics on licensing exams, understanding the existence and purpose of such ratios is essential.

From a rights standpoint, ADR holders generally enjoy many of the same benefits as traditional shareholders, including the right to receive dividends and, in some cases, limited voting rights. However, for exam purposes, it's important to note that ADRs do not carry preemptive rights—meaning holders cannot purchase additional shares before the general public if the foreign company issues more stock. Voting rights may be limited or exercised indirectly through the depositary bank, depending on the terms of the ADR. Investors in ADRs also face risks that go beyond those associated with domestic equity investments. Chief among these is currency risk—the potential for changes in foreign exchange rates to affect investment returns. Since ADRs are backed by foreign assets, any depreciation in the local currency against the U.S. dollar can reduce the value of the ADR, even if the price of the foreign stock remains stable in its local market. Additionally, international tax laws apply. While dividends are converted and paid in U.S. dollars by the depositary banks, foreign governments often impose withholding taxes on those dividends. Fortunately, investors may be able to claim a foreign tax credit on their U.S. tax return to offset these foreign tax obligations.

Another key concept to understand is the issuer of ADRs. These securities are issued by U.S. banks—usually their domestic branches—which act as intermediaries between U.S. investors and the foreign companies. Although ADRs are priced in U.S. dollars and traded on U.S. markets, they remain tied to international investments and are thus still exposed to currency and geopolitical risks. Beyond ADRs, investors may also consider investing directly in foreign markets to diversify their portfolios. Foreign investments can be broadly categorized into emerging markets and developed markets, each with distinct characteristics, opportunities, and risks. Emerging markets refer to countries in the early stages of economic development. These nations typically have lower GDP per capita, smaller and less mature financial markets, and may suffer from limited market liquidity and infrastructure inefficiencies. Their stock markets often experience higher volatility due to less regulatory oversight, potential restrictions on currency conversion, and a generally higher level of political and social instability. Furthermore, foreign investors in these markets may face elevated transaction costs, such as higher brokerage commissions, local taxes, and currency control regulations that can limit the ability to repatriate profits. However, what makes emerging markets attractive is their potential for rapid economic growth, driven by expanding middle classes, industrialization, and demographic advantages. Countries like India, Indonesia, and Brazil are commonly cited as examples of emerging markets.

There’s also the concept of frontier markets, which are even less developed than emerging markets. These countries may have nascent capital markets, extremely limited liquidity, and high geopolitical risk. Still, they offer early access to fast-growing economies that have not yet been heavily penetrated by foreign investment. While these markets carry elevated risk, they may provide uncorrelated returns and high reward potential for investors with a long-term view and high-risk tolerance. In contrast, developed markets are found in countries with advanced economies, robust legal systems, and mature capital markets. These include the United States, Japan, Germany, the United Kingdom, and Canada. Developed markets typically offer high market liquidity, transparent financial reporting, and well-regulated trading environments. Investors benefit from lower transaction costs, minimal restrictions on foreign ownership, and currency stability. While these markets may offer more stable returns than emerging markets, they often grow at a slower pace, which is why investors diversify globally in order to combine stability with growth potential.

Investing in foreign securities through ADRs can enhance a portfolio by increasing diversification and potentially improving risk-adjusted returns. Foreign equities often show low correlation with U.S. markets, meaning they don’t always move in tandem. This can reduce overall portfolio volatility and increase the potential for higher returns in differing economic cycles. Moreover, some international companies may outperform their U.S. counterparts due to regional economic booms, favorable demographics, or unique technological advancements.

However, foreign investing comes with unique risks. One of the most comprehensive is country risk, which encompasses political instability, economic mismanagement, regulatory unpredictability, and sudden policy changes—such as capital controls, nationalizations, or confiscatory taxes. For example, an investor may face the risk of a foreign government expropriating assets or introducing sudden laws that restrict foreign ownership. These factors make geopolitical analysis critical when selecting foreign securities. Another concern is exchange control risk, where a country imposes restrictions on the movement of capital across borders. This might prevent investors from converting profits into U.S. dollars or moving money out of the country entirely. Such controls are more common in emerging and frontier markets, where governments may intervene to stabilize their currency or protect domestic financial systems. Withholding taxes and fees can also significantly affect returns. Some foreign governments automatically withhold a portion of dividends and capital gains for tax purposes before distributing them to investors. Additionally, brokerage fees and regulatory costs can be higher in international markets. Although many of these taxes may be recoverable through tax credits, navigating them requires knowledge and proper documentation.