American Deposit Receipts Bear Risks

There is a common misconception that investing in a bundle or basket of European ADR’s (American Depository Receipts) carries no risk of loss due to currency exchange. Many believe that because ADR’s are traded in the US, and in US dollars, that there is no foreign exchange dynamic or element involved, thereby neutralizing the risk depreciation in value due to exchange rate differentiation. Unfortunately, this is not true. ADR’s traded in the US in American dollars still bear the of the local currency market. Below you will find a brief explanation of why this is so.

ADR’s are generated through global banks that possess an exorbitant amount of international agencies’ and firms’ local shares. Based on the local currency rate, the bank then sets an ADR conversion rate. What this means is that an ADR is worth a certain number of local shares based on the local currency rate. This conversion rate establishes a direct link between the ADR security and the current local currency rate.

The direct correlation between currency and ADRs creates the continuum and tension that preserves the conversion relation as time progresses. As movement in the exchange rate is experienced based on the local currency, the variation is reflected in the value of the ADR. This relationship process must be in effect in order to protect the conversion rate that has been established by the bank.

To illustrate currency based valuation of ADRs, if by some chance the local value of a foreign security remains the same, but the exchange rate against the dollar declines by 25 percent, the US traded ADR would decrease in value by the same amount as a reflection of the conversion rate that was initially established by the global bank that generated the ADR.

This must be understood in the light of foreign securities local rates having direct correlation against the measurement of the ADR that is traded in America in US dollars must be reflected in its relationship to the local foreign security by which the conversion rate was established. If the correlation between the two securities is not maintained then the conversion ratio that is created by the bank has no true value or measurement.

In sum, ADR’s are traded in American dollars for the sake of making the trade process easier to transact, but the investments associated with these trades are still vulnerable to the fluctuation in exchange rates.