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Explain depository receipts and investing in foreign equities

CFA® Level I · Equities · Equity Instrument Features · EQ.6.c

The idea

A depository receipt is a security issued in one market representing shares held in another, letting an investor obtain foreign exposure in their own market, currency and settlement system. A sponsored receipt is created with the cooperation of the issuing company and carries voting and information rights; an unsponsored one is created by a depository bank without that cooperation and generally does not. Global depository receipts trade outside both the issuer's and the United States markets. The receipt does not remove currency risk: its price reflects the foreign share price translated at the prevailing rate.

Formulas

Price of a depository receipt

P_r = P_s × X × n

P_r
the receipt price in the home currency
P_s
the share price in the foreign currency
X
the home currency per unit of foreign currency
n
the number of foreign shares in one receipt

The receipt holder bears both the share-price risk and the currency risk.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does a depository receipt represent?

  1. A loan to a foreign companyWhy not: A receipt is an ownership claim, not a debt. The holder takes equity risk on the underlying shares.
  2. Foreign shares held on deposit - correct
  3. An option to buy foreign sharesWhy not: No optionality is involved: the underlying shares already sit with the depository bank.

A depository receipt lets investors buy a foreign company through their home market. A bank, called the depository, holds the foreign shares. It issues receipts that are claims on those shares, and the receipts trade locally like ordinary shares. So the holder owns an equity claim, not a loan and not an option. Idea: one receipt = a fixed number of underlying foreign shares held by the bank.

A harder one

What is the main difference between sponsored and unsponsored depository receipts?

  1. Sponsored receipts are created with the issuer's cooperation and carry voting and information rights - correct
  2. Sponsored receipts trade only in the United States, while unsponsored ones trade elsewhereWhy not: Sponsorship is about the issuer's participation, not the listing venue; sponsored programmes exist outside the United States too.
  3. Unsponsored receipts each represent a larger number of underlying shares than sponsored onesWhy not: The ratio of shares to receipts is a design choice in either programme and is unrelated to sponsorship.

In a sponsored programme, the company itself agrees the arrangement with the depository bank. Holders therefore usually get voting rights and company information. In an unsponsored programme, the bank creates the receipts without the company's involvement, so holders generally have limited or no voting rights. For example, a sponsored holder can usually vote through the bank, while an unsponsored holder may receive only the economic benefit. Both give exposure to the foreign shares, and neither depends on where they are listed or how many shares each receipt covers.

The hardest tier

What is the main reason an investor might prefer a depository receipt to buying the foreign share directly?

  1. Because it removes the underlying company's business riskWhy not: The receipt is a claim on those very shares, so every bit of the business risk comes with it.
  2. Because receipts carry a guaranteed dividendWhy not: The dividend is whatever the foreign company pays, passed through and translated, with no guarantee attached.
  3. Because it avoids foreign custody and settlement - correct

A depository receipt gives the same exposure as the foreign share, but it is bought, held and settled in the investor's own market. A US investor avoids opening a foreign brokerage and custody account (custody means safekeeping of the shares) and dealing with foreign settlement (the process of exchanging cash for shares). The business risk, the uncertainty over dividends and the currency exposure are all unchanged. The benefit is convenience, not lower risk, and nothing about the dividend becomes guaranteed.

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