I write this quarter's article, during the week preceding a highly anticipated IPO (initial public offering) for a foreign stock. The news surrounding this stock is everywhere: Newspapers, magazines, and just about every financial web site that I can visit is touting it as possibly the biggest IPO ever. Who am I talking about? Well by the time this article is published - it will no longer matter, as this stock will have been trading publically for weeks, and point of this article is not a stock tip anyway.
Did you ever wonder how foreign based companies can offer shares of their stock over here in the USA; traded on U.S stock exchanges? How is it that one can purchase shares of a Chinese, Japanese, or French based companies in U.S. dollars? The answer is a financial product referred to as American Depositary Receipts (ADR's). In very simple terms, ADR's are U.S. certificates, held by a bank and registered with the SEC, that represent a number of shares of a foreign stock. It is these certificates that are traded on U.S. stock exchanges in U.S. dollars, yet they represent the U.S. dollar equivalent unit for the foreign stock unit(s) after the units are standardized.
ADRs do have some risks besides the risks that affect all stocks. Currency fluctuations are a major risk. Even though the American investor can deal in US dollars, the value of the ADR will fluctuate along with the currency exchange rate between the US dollar and the currency of the company's country. Another major risk is political risk. The enactment of unfavorable tax laws or other laws that may have an adverse effect on the flow of capital or on investments can also lower the value of the ADR. Political instability and corruption can also have a major influence on ADR prices. In general, ADRs from more stable countries, will tend to fluctuate less than ADRs from unstable countries.
Beyond these risks that all ADR's hold in common, another newer one specific to Chinese ADR's has piled on. It is an organizational work-around referred to as Variable Interest Entity structure (VIE). This idea was first created in 2000 to circumvent certain Chinese restrictions, and allow for companies to list in the U.S. Yet, while many Chinese ADR's operate under this work around structure, the Chinese government has ruled this structure to be illegal in certain cases -- after the fact. Hence, another risk.
Of course, many of these investments may be profitable, and suitable for many investors. Yet many may not, and thinking that ADR's are simply all the same, and have the same risks as U.S. stocks do, is simply not the right understanding to have.
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