Why American Depositary Receipts Have Currency Risk

American Depositary Receipts (ADRs) are a common investment vehicle for those seeking exposure to international markets. Despite trading in U.S. dollars, ADRs inherently carry currency risk that can influence investor returns. This article explains why this risk exists and how it impacts their value.

Defining American Depositary Receipts

American Depositary Receipts are negotiable certificates issued by a U.S. depositary bank that represent shares of a foreign company’s stock. These certificates allow U.S. investors to trade foreign company shares on U.S. stock exchanges, such as the NYSE or Nasdaq. The underlying shares are held by the U.S. depositary bank in the foreign company’s home country.

ADRs are denominated in U.S. dollars and clear through U.S. settlement systems, making them accessible through American brokers. Each ADR can represent a fraction, a single share, or multiple shares of the foreign security, with the depositary bank setting a conversion ratio.

Understanding Currency Exchange Risk

Currency exchange risk is the possibility that an investment’s value will change due to fluctuations in the exchange rate between two currencies. Exchange rates determine how much one currency is worth in terms of another, and these rates are influenced by various economic factors.

When converting the foreign currency value back to the investor’s home currency, such as the U.S. dollar, gains or losses can occur. For example, if the U.S. dollar strengthens against a foreign currency, the value of foreign assets held by a U.S. investor will decrease when translated back into U.S. dollars. Conversely, a weakening U.S. dollar can increase the U.S. dollar value of foreign holdings.

The Interplay of ADRs and Currency Risk

Despite trading in U.S. dollars on U.S. exchanges, American Depositary Receipts are not immune to currency risk. The underlying company’s financial performance—its revenues, expenses, and profits—are denominated in its home country’s local currency. This means the ADR’s value is directly influenced by the foreign company’s stock price in its local market and the exchange rate when converted to U.S. dollars.

Any movement in the exchange rate between the foreign currency and the U.S. dollar must be reflected in the ADR’s price. If the U.S. dollar strengthens against the foreign currency, the ADR’s U.S. dollar value will decrease, even if the foreign company’s stock price remains unchanged. Conversely, a weakening U.S. dollar can lead to an increase in the ADR’s value in U.S. dollars.

Dividends paid by the foreign company also experience currency risk. When a foreign company declares a dividend, it is initially in its local currency. The depositary bank then collects these dividends, converts them into U.S. dollars, and distributes them to ADR holders. Fluctuations in the exchange rate can affect the final U.S. dollar amount of the dividend received by the investor, with a stronger U.S. dollar reducing the payout and a weaker U.S. dollar increasing it.

Illustrative Examples of Currency Impact

Consider a U.S. investor holding an ADR for a European company, with the underlying share trading in euros. If the ADR is priced at $50 and the exchange rate is €1.00 to $1.10, the underlying value in euros would be approximately €45.45. If the euro weakens to €1.00 to $1.00 (U.S. dollar strengthens), the ADR’s U.S. dollar value would drop to $45.45, assuming the euro price of the underlying share remains constant. This illustrates a loss for the U.S. investor due to currency movement alone.

Conversely, if the U.S. dollar weakens and the euro strengthens, for example, to €1.00 to $1.20, the same underlying share worth €45.45 would translate to $54.54. The U.S. investor would see an increase in their ADR’s U.S. dollar value, even without any change in the foreign company’s performance. Similarly, a dividend of €1.00 would yield $1.10 when the exchange rate is €1.00 to $1.10, but only $1.00 if the dollar strengthens, or $1.20 if the dollar weakens.