What’s the ways to have exposure to foreign securities such as Tencent(trading in Hong Kong Stock Exchange)? Of course, one way is to open an broker account in Hong Kong and buy the stock in that broker account. Another easier way is to trade ADRs in US with local brokers.
So what’s ADR?
ADR(American Depositary Receipts) is a stock that trades in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage.
There are 3 types of ADR:
- Level 1 – This is the most basic type of ADR where foreign companies either don’t qualify or don’t wish to have their ADR listed on an exchange. They only trade OTC.
- Level 2 – This type of ADR is listed on an exchange or quoted on Nasdaq.
- Level 3 – This type of ADR is issued a IPO on a US exchange.
Once an ADR is priced and sold on the market, it’s price is determined by supply and demand, just like an ordinary stock. However, if the US price varies too far from the corresponding stock in home country(taking the currency exchange and ratio of ADRs to home country shares into account), arbitrager will come in and make the price close to it’s fair value. So ADRs tend to follow the general trend of the home country stock but this is not always the case.
ADR has it’s own unique risks other than ordinary stock.
- Political Risk – The characteristic of foreign government may affect the price of ADR.
- Exchange Rate Risk – The currency exchange rate will influence the price of ADR.
- Inflationary Risk – This is an extension of the exchange rate risk. Currency of a country with high inflation becomes less and less valuable.
We tend to use continuous rate to calculate forward price because it’s hard to compare forward price if market convention is different. For example, a 4% three-month rate in US dollar market is not the same as a 4% three-month rate in the UK sterling market. This is because USD ear fractions are calculated on an actual/360 basis while GBP rates are calculated on an actual/365 basis.
Here is the formula to convert market rates to continuous rates:
For investment assets, interest rates and storage cost increase forward price, while income reduces forward price. The overall relationship is called the cost of carry for an asset.
The overall future price equation, if all rates are quoted using a continuously-compounded basis, is: