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Depository receipt

A depositary receipt (DR) is a type of negotiable(transferable) financial security that is traded on alocal stock exchange but represents a security,usually in the form of equity, that is issued by aforeign publicly-listed company.

The DR, which is a physical certificate, allowsinvestors to hold shares in equity of othercountries.

One of the most common types of DRs is theAmerican depositary receipt (ADR), which hasbeen offering companies, investors and tradersglobal investment opportunities since the 1920s.

DRs have spread to other parts of the globe in theform of global depositary receipts (GDRs)European DRs and International DRs.

ADRs are typically traded on a U.S. national stockexchange, such as the New York Stock Exchange(NYSE) or the American Stock Exchange, whileGDRs are commonly listed on European stockexchanges such as the London Stock Exchange.

Both ADRs and GDRs are usually denominated inU.S. dollars, but can also be denominated ineuros.


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How Does the DR Work?

The DR is created when a foreign company wishes tolist its already publicly-traded shares or debt securitieson a foreign stock exchange.

Before it can be listed to a particular stock exchange,the company in question will first have to meet certain

requirements put forth by the exchange. Initial public offerings, however, can also issue a DR. DRs can be traded publicly or over-the-counter. Example

Say a gas company in Russia has fulfilled therequirements for DR listing and now wants to list itspublicly-traded shares on the NYSE in the form of an

ADR. Before the gas company's shares are traded freely on the

exchange, a U.S. broker, through an international office ora local brokerage house in Russia, would purchase thedomestic shares from the Russian market and then havethem delivered to the local (Russian) custodian bank ofthe depository bank.

The depository bank is the American institution that issues

the ADRs in America. In this example, the depositorybank is the Bank of New York. Once the Bank of New York's local custodian bank in

Russia receives the shares, this custodian bank verifiesthe delivery of the shares by informing the Bank of NewYork that the shares can now be issued in the UnitedStates.


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Example (contd.)

The Bank of New York then delivers the ADRs tothe broker who initially purchased them.

Based on a determined ADR ratio, each ADR maybe issued as representing one or more of theRussian local shares, and the price of each ADR

would be issued in U.S. dollars converted from theequivalent Russian price of the shares being heldby the depository bank.

The ADRs now represent the local Russian sharesheld by the depository, and can now be freelytraded equity on the NYSE.

After the process whereby the new ADR of theRussian gas company is issued, the ADR can betraded freely among investors and transferred fromthe buyer to the seller on the NYSE, through aprocedure known as intra-market trading.

All ADR transactions of the Russian gas companywill now take place in U.S. dollars and are settledlike any other U.S. transaction on the NYSE.

The ADR investor holds privileges like thosegranted to shareholders of ordinary shares, such asvoting rights and cash dividends. The rights of theADR holder are stated on the ADR certificate.


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Pricing and Cross-Trading

When any DR is traded, the broker will aim to find thebest price of the share in question.

He or she will therefore compare the U.S. dollar price ofthe ADR with the U.S. dollar equivalent price of thelocal share on the domestic market.

If the ADR of the Russian gas company is trading atUS$12 per share and the share trading on the Russianmarket is trading at $11 per share (converted fromroubles to dollars), a broker would aim to buy morelocal shares from Russia and issue ADRs on the U.S.market.

This action then causes the local Russian price and the

price of the ADR to reach parity. The continual buyingand selling in both markets, however, usually keeps theprices of the ADR and the security on the home marketin close range of one another. Because of this minimalprice differential, most ADRs are traded by means ofintra-market trading.

A U.S. broker may also sell ADRs back into the localRussian market. This is known as cross-border trading.

When this happens, an amount of ADRs is canceled bythe depository and the local shares are released fromthe custodian bank and delivered back to the Russianbroker who bought them. The Russian broker pays forthem in roubles, which are converted into dollars by theU.S. broker.


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The Benefits of DepositaryReceipts

The DR functions as a means to increase global trade, whichin turn can help increase not only volumes on local and foreignmarkets but also the exchange of information, technology,regulatory procedures as well as market transparency.

Thus, instead of being faced with impediments to foreigninvestment, as is often the case in many emerging markets,the DR investor and company can both benefit frominvestment abroad.

For the Company A company may opt to issue a DR to obtain greater exposure

and raise capital in the world market. Issuing DRs has the added benefit of increasing the share's

liquidity while boosting the company's prestige on its localmarket ("the company is traded internationally"). Depositary receipts encourage an international shareholder

base, and provide expatriates living abroad with an easieropportunity to invest in their home countries.

Moreover, in many countries, especially those with emergingmarkets, obstacles often prevent foreign investors fromentering the local market.

By issuing a DR, a company can still encourage investmentfrom abroad without having to worry about barriers to entrythat a foreign investor might face.


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Benefits for the Investor

Buying into a DR immediately turns an investors'portfolio into a global one.

Investors gain the benefits of diversification, while

trading in their own market under familiarsettlement and clearance conditions.

DR investors will be able to reap the benefits ofthese usually higher-risk, higher-return equities,without having to endure the added risks of goingdirectly into foreign markets, which may pose lack

of transparency or instability resulting fromchanging regulatory procedures.

It is important to remember that an investor willstill bear some foreign-exchange risk, stemmingfrom uncertainties in emerging economies and

societies. On the other hand, the investor can also benefit

from competitive rates the U.S. dollar and eurohave to most foreign currencies.


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Definition of Important Terms

Domestic Custodian Bank means a banking company which acts as a custodian for

the ordinary shares or foreign currency convertible bondsof an Indian Company which are issued by it againstglobal depositary receipts or certificates;

Foreign Currency Convertible Bonds means bonds issued in accordance with this scheme and

subscribed by a non- resident in foreign currency andconvertible into ordinary shares of the issuing company inany manner, either in whole, or in part, on the basis of anyequity related warrants attached to debt instruments;

Global Depositary Receipts means any instrument in the form of a depositary receipt

or certificate (by whatever name it is called) created bythe Overseas Depositary Bank outside India and issued tonon- resident investors against the issue of ordinaryshares or Foreign Currency Convertible Bonds of issuingcompany;

Issuing Company means an Indian company permitted to issue Foreign

Currency Convertible Bonds or ordinary shares of that

company against Global Depositary Receipts; Overseas Depositary Bank

means a bank authorised by the issuing company to issueglobal depositary receipts against issue of ForeignCurrency Convertible Bonds or ordinary shares of theissuing company;


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What Is An ADR?

Introduced to the financial markets in 1927, an Americandepositary receipt (ADR) is a stock that trades in the UnitedStates but represents a specified number of shares in aforeign corporation.

ADRs are bought and sold on American markets just likeregular stocks, and are issued/sponsored in the U.S. by abank or brokerage.

ADRs were introduced as a result of the complexities involvedin buying shares in foreign countries and the difficultiesassociated with trading at different prices and currency values.

For this reason, U.S. banks simply purchase a bulk lot ofshares from the company, bundle the shares into groups, andreissues them on either the New York Stock Exchange(NYSE), American Stock Exchange (AMEX) or the Nasdaq.

In return, the foreign company must provide detailed financialinformation to the sponsor bank.

The depositary bank sets the ratio of U.S. ADRs per home-country share.

This ratio can be anything less than or greater than 1. This isdone because the banks wish to price an ADR high enough toshow substantial value, yet low enough to make it affordablefor individual investors.

Most investors try to avoid investing in penny stocks, andmany would shy away from a company trading for 50 Russianroubles per share, which equates to US$1.50 per share.

As a result, the majority of ADRs range between $10 and $100per share. If, in the home country, the shares were worthconsiderably less, then each ADR would represent severalreal shares.


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Types of ADR issues

There are three different types of ADR issues: Level 1 - This is the most basic type of ADR where

foreign companies either don't qualify or don't wish tohave their ADR listed on an exchange. Level 1 ADRsare found on the over-the-counter market and are an

easy and inexpensive way to gauge interest for itssecurities in North America. Level 1 ADRs also havethe loosest requirements from the Securities andExchange Commission (SEC).

Level 2 - This type of ADR is listed on an exchange orquoted on Nasdaq. Level 2 ADRs have slightly morerequirements from the SEC, but they also get higher

visibility trading volume. Level 3 - The most prestigious of the three, this is whenan issuer floats a public offering of ADRs on a U.S.exchange. Level 3 ADRs are able to raise capital andgain substantial visibility in the U.S. financial markets.

American Depository Share - ADS A share issued under deposit agreement that

represents an underlying security in the issuer's homecountry.

The term ADR and ADS are often thought to be thesame. Technically, an ADS is the actual share trading,while an ADR represents a bundle of ADS's.


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ADR Risks

There are several factors that determine the value ofthe ADR beyond the performance of the company.Analyzing these foreign companies involves furtherscrutiny than merely looking at the fundamentals. Hereare some other risks that investors should consider:

Political Risk - Ask yourself if you think the governmentin the home country of the ADR is stable? For example,you might be wary of Russian Vodka Inc. because ofthe characteristic instability of the Russian government.

Exchange Rate Risk - Is the currency of the homecountry stable? Remember the ADR shares track the

shares in the home country. If a country's currency isdevalued, it will trickle down to your ADR. This canresult in a big loss, even if the company had beenperforming well.

Inflationary Risk - This is an extension of the exchangerate risk. Inflation is the rate at which the general levelof prices for goods and services is rising and,

subsequently, purchasing power is falling. Inflation canbe a big blow to business because the currency of acountry with high inflation becomes less and lessvaluable each day.


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The Process

The process of issuing an ADR usually starts by seeking afinancial advisor, an international investment bank, or may beinitiated by a foreign investment bank that recognizes theattraction to a company for its money management clients(and of course the fees generated for its own bottomline).

The advisor would then contact commercial banks that can actas a depository in the foreign market and as a custodian in thedomestic market and form the depository trust against sharesheld in the domestic market.

The depository bank also carries out all the necessarycorporate actions like dividend payments and votingprocedures etc.

The issuing company decides on the number of shares to be

sold in the foreign market. After delivering these shares to the custodian bank, the

custodian registers them in the depository banks name.

The depository bank then issues the required number ofreceipts.

The ratio of receipts issued to shares deposited varies fromcompany to company.

In the case of Infosys, each ADR is one half of the domesticshare whereas in the case of TSP, a Brazilian telephonecompany, each ADR represents 1,000 preferred shares of theunderlying shares.


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The Process (contd.)

To set the price of the ADR, the advisor goes through a pricediscovery process as dictated by the markets, participants,and the supply-demand considerations.

The advisor might invite other investment banks to join it toform a syndicate.

The syndicate should have more financial muscle and biggerclient base to place the issue in the market. A foreign investor may find it beneficial to invest in an ADR as

opposed to a domestic share, for a variety of reasons lack of custody or safekeeping agent in the foreign market, difficult settlement procedures for share purchase and

transaction costs associated with foreign currencies. The ADRs, from the perspective of a foreign buyer, may

be more liquid as they trade among large institutionalinvestors and can be sold in bulk. The liquidity makes for quicker execution and less

transaction costs.

The issuing process usually goes smoothly, but at times hitssnags or is cancelled or postponed. Unfavorable marketconditions like the global crisis in 1997 and 1998 or the issuing

companys reluctance to accept a market determined price forits G/ADR can upset the cart.


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Global Depository Receipt - GDR

A bank certificate issued in more thanone country for shares in a foreigncompany. The shares are held by a

foreign branch of an international bank.The shares trade as domestic shares, butare offered for sale globally through thevarious bank branches.

A financial instrument used by privatemarkets to raise capital denominated ineither U.S. dollars or euros.

A GDR is very similar to an AmericanDepository Receipt

These instruments are called EDRs whenprivate markets are attempting to obtaineuros.

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