American depositary shares (ADS) come into play when a foreign company wants its shares to trade on a major American exchange. Securities laws prevent foreign corporations that have shares trading in a foreign market to directly list their shares on U.S. stock exchanges (exceptions do occur, such as for Canadian companies).

Because of this, foreign companies are forced to create ADS, which represent the full rights of the common stock they are based on. ADS are then securely held by a bank or financial institution in the foreign company's country, at which point American depositary receipts (ADR) are created to represent the ADS and are listed on the desired American exchange.

ADR are typically the units investors buy and sell on U.S. exchanges. ADR represent the ADS units held by the custodian bank in the foreign company's home country. ADR can be issued against ADS at any ratio the company chooses. For example, ABC company could have ADR trading on the New York Stock Exchange (NYSE) These ADR could be issued at a rate of five ADR equal to one American Depository Share (5:1), or any other ratio the company chooses.

The underlying ADS, however, most often correspond directly to the foreign company's common shares. In other words, the ratio of ADS to common shares is usually one, while the ratio of ADR to ADS can be whatever a company decides to issue them at. Sometimes firms can issue ADS to represent more than one common share each, but usually the ratio is one-to-one.

To learn more about this topic, consider reading our ADR Basics Tutorial and What Are Depositary Receipts?

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