What Are Depository Receipts and How Do They Work?

Depository receipts offer a pathway for investors to engage with companies operating beyond their home country’s borders. These financial instruments facilitate cross-border investment by providing a localized trading vehicle for shares of foreign corporations. They simplify the process for investors to gain exposure to international markets without directly navigating foreign stock exchanges. This structure broadens investment opportunities, allowing for diversification across different global economies.

Defining Depository Receipts

A depository receipt is a negotiable security representing ownership in shares of a foreign company. It allows investors to hold shares of a non-domestic company and trade them on their local stock exchange. The purpose of these receipts is to simplify international investment, bypassing complexities often associated with direct foreign stock purchases, such as foreign currency conversions, different trading hours, and diverse regulatory environments.

These receipts are issued by a depository bank. The underlying shares are held in custody by a custodian bank located in the foreign company’s home country. This arrangement means investors own the receipt, which represents their beneficial interest in the foreign shares. The value of a depository receipt is directly linked to the price of the underlying shares, adjusted for any share-to-receipt ratio.

How Depository Receipts Work

The process involves several key entities. The foreign company’s shares are the foundation of the receipt. A custodian bank in the foreign company’s home country holds these shares. This custodian bank then communicates with the depository bank.

The depository bank, based in the investor’s local market, issues the depository receipts. After the foreign company’s shares are deposited with the custodian bank, the custodian notifies the depository bank. The depository bank then creates and issues the corresponding number of depository receipts in the local market for investors to purchase.

When the foreign company declares dividends or undertakes corporate actions, these are processed through the same structure. The custodian bank receives dividends from the foreign company and remits funds to the depository bank. After currency conversion and deducting fees or withholding taxes, the depository bank distributes payments to receipt holders. Corporate actions like stock splits, rights offerings, or mergers are mirrored in the depository receipt, ensuring holders experience the same benefits as direct shareholders.

Common Types of Depository Receipts

Depository receipts are primarily categorized by where they are traded and the level of involvement from the foreign company. American Depository Receipts (ADRs) are the most common type for U.S. investors, representing shares of non-U.S. companies and traded on U.S. exchanges or over-the-counter markets. Global Depository Receipts (GDRs) are similar but are traded on multiple international stock exchanges outside both the issuer’s home country and the United States, providing broader global access.

Further distinction exists between “sponsored” and “unsponsored” depository receipts. Sponsored receipts are issued with the direct involvement and approval of the foreign company. The foreign company bears the costs associated with the program, and these receipts offer greater transparency, requiring the foreign company to comply with regulatory reporting requirements in the market where the receipts are traded. This direct involvement means more information is available to investors.

In contrast, unsponsored receipts are initiated by a depository bank without the direct participation or consent of the foreign company. These receipts are created in response to investor demand for a foreign company’s shares. While they provide investment access, unsponsored programs offer less financial information to investors, and the foreign company has no ongoing obligations or benefits from the program.

Trading and Market Aspects

Depository receipts offer investors a convenient way to trade shares of foreign companies through familiar market mechanisms. In the U.S., ADRs can be listed on major stock exchanges like the New York Stock Exchange (NYSE) or Nasdaq, or traded over-the-counter (OTC) through a network of brokers. Their trading hours align with the local market, allowing investors to buy and sell during regular business hours without foreign market schedule concerns.

The price of a depository receipt is directly influenced by the underlying foreign shares. Arbitrage maintains this relationship, as market participants exploit price differences between the receipt and shares. The exchange rate between the foreign company’s home currency and the local trading currency, along with the ratio of receipts to underlying shares, also impacts the receipt’s price. For instance, if one receipt represents ten foreign shares, its price will roughly be ten times the price of one foreign share, adjusted for currency conversion.

Factors that can affect the market price of depository receipts include the financial performance of the underlying company, which directly impacts the value of its shares. Currency fluctuations between the two countries’ currencies can also lead to gains or losses for investors, independent of the company’s performance. Market demand and supply for the underlying foreign stock and the depository receipt also play a role in determining its market price.