1. ADR Basics: Introduction
  2. ADR Basics: What Is An ADR?
  3. ADR Basics: Determining Price
  4. ADR Basics: Risks
  5. ADR Basics: Conclusion

Now that we’ve covered how ADRs are established and sold to the public, we’ll look at how the price of an ADR is determined. 

ADR Ratio

An ADR may represent the underlying shares of the non-U.S. company on a one-to-one basis, or it can be a fraction of a share or multiple shares. One ADR, for example, could represent four shares of an underlying security (a 4:1 ratio), while another ADR could represent half a share (0.5:1). This allows ADRs to be priced at an amount that’s typical for U.S. market share prices, while pricing the ADR high enough to show substantial value, yet low enough to make it affordable for individual investors.

Here’s an example. Suppose a recent boom in the popularity of craft chocolates (similar to craft beer or coffee) has increased the prospects for the cocoa industry. Brazil Cocoa Inc. (a hypothetical company) wants to list shares on the NYSE to gain exposure to the U.S. market and tap into the growing demand for craft chocolates. 

Brazil Cocoa Inc. already trades on the B3 (a Brazilian stock exchange) at 50 Brazilian Reals per share, which (as of Oct.21, 2017) equals US$15.66. Let's say that a U.S. bank buys 30 million shares from Brazil Cocoa Inc. and issues them in the U.S. at a ratio of 2:1. This means each ADR share you purchase is worth 2 shares on the B3 stock exchange. A quick calculation tells us that the new ADR should have an issue price of around US$31.32 each (2 times $15.66). 

Supply and Demand

Once an ADR is priced and sold on the market, its price is determined by supply and demand, just like an ordinary stock. ADRs tend to follow the general trend of the home country shares, but this is not always the case. If the U.S. price varies too far from the Brazilian price after taking into consideration the currency exchange rate and the ratio of ADRs to home country shares, an arbitrage opportunity may arise. Indeed, like other markets, arbitrage trading has played a role in the ADR market since J.P. Morgan created the first ADR in 1927.

As J.P. Morgan stated in a Feb. 2014 edition of its DR Advisor Insights, “It is commonly known that ADRs and their underlying shares trade independently: although they are fully fungible with each other, their relative prices are not at all times the same. Hedge funds and trading firms attempt to capitalize on this asymmetry, generating revenue from periodic, short-term, FX-adjusted price difference between a company’s ADR and its underlying, local security.”

J.P. Morgan adds that firms engaging in ADR arbitrage don’t create the difference in price – they merely react to and capitalize on it using short-term trading strategies. In general, arbitrage strategies don’t work for small, retail traders and investors. They can, however, be very profitable for institutional investors, who have more trading capital, more skill, access to up-to-the second news, faster computers, complex software (like algorithms to spot arbitrage opportunities) and access to the dealing desk. While arbitrage and the trading firms that employ arbitrage strategies are controversial, proponents say the practice helps create market liquidity, which is good for all investors. (For me, read: Arbitrage Strategies.)  

ADRs present many other unique risks to investors; we'll examine these in the following section.

ADR Basics: Risks
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