An American Depositary Receipt is a means for American investors to invest easily in foreign stocks. An American Depositary Receipt is traded on American stock exchanges in US dollars. However, its value is dependent upon how the foreign stock the American Depositary Receipt represents is doing on the foreign exchange on which the stock is listed.
A US bank or an international bank purchases an amount of stock in a foreign company. It then creates a financial instrument, the American Depositary Receipt, to sell on a US listed exchange. Investors in the United States are then able to indirectly invest in this foreign company using US dollars. This allows the American investor to avoid a great deal of administration and duty costs that would be incurred if the foreign stock were held directly.
The US or international bank either charges a management fee, which is included in the price of the American Depositary Receipt, or receives a fee from the foreign company. In the latter case, the foreign company is willing to pay for the benefit of exposure to a much larger market, the American market.
The US bank that sets up the American Depositary Receipt also frequently partners with a second US bank. The bank initiating the process is usually a large investment bank specializing in large scale investments. This investment bank will partner with a depositary bank who can specialize in the day to day business of buying and selling each individual American Depositary Receipt and paying out any dividends. This arrangement allows the investment bank to specialize in what it does best and the depository bank to focus on its area of expertise. Both functions are required, and even very large banks may not have or wish to have all of the required expertise in house.
American investors can use an American Depositary Receipt as an easy way to regionally diversify their investments. It frequently happens that the economy in one region of the world may be booming while another region is in a recession. By investing in a number of regions, the investor expects that overall portfolio returns will be more regular. American Depositary Receipts also allow American investors to easily invest in the best companies in the world regardless of which world market they trade on.