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If a multinational firm based in country A is listed in both country A and country B, and I invest in this firm as a resident of country B through country B's stock exchange, either through something like an ADR or because the company is listed directly, like Apple, am I still exposed to currency risk as if I had bought the stock on country A's exchange directly through an international broker (for example)?

I understand that I'll be exposed to currency risk on the dividend payments. I'm just wondering about currency risk when I sell the stock at the end of the holding period then having to convert it back to domestic currency.

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Yes, you're still exposed to currency risk when you purchase the stock on company B's exchange. I'm assuming you're buying the shares on B's stock exchange through an ADR, GDR, or similar instrument. The risk occurs as a result of the process through which the ADR is created. In its simplest form, the process works like this:

  1. An international bank buys shares in the company on country A's stock exchange.
  2. The bank chooses a conversion rate. This is the number of shares they want to offer on country B's stock exchange per each share they purchased on country A's exchange. This conversion rate includes the exchange rate between the two currencies.

Example

I'll illustrate this with an example. I've separated the conversion rate into the exchange rate and a generic "ADR conversion rate" which includes all other factors the bank takes into account when deciding how many ADR shares to sell. The fact that the units line up is a nice check to make sure the calculation is logically correct. My example starts with these assumptions:

  1. The price of the company on a European stock exchange is 50 EUR/share.
  2. The exchange rate is 1.29056 USD/EUR.
  3. I made up the generic ADR conversion rate; it will remain constant throughout this example.

    This is the simplified version of the calculation of the ADR share price from the European share price:

original exchange rate

Let's assume that the euro appreciates against the US dollar, and is now worth 1.4 USD (this is a major appreciation, but it makes a good example):

euro appreciation, no euro share price change

The currency appreciation alone raised the share price of the ADR, even though the price of the share on the European exchange was unchanged. Now let's look at what happens if the euro appreciates further to 1.5 USD/EUR, but the company's share price on the European exchange falls:

euro appreciation, euro share price decrease

Even though the euro appreciated, the decline in the share price on the European exchange offset the currency risk in this case, leaving the ADR's share price on the US exchange unchanged.

Finally, what happens if the euro experiences a major depreciation and the company's share price decreases significantly in the European market? This is a realistic situation that has occurred several times during the European sovereign debt crisis.

euro depreciation, euro share price decrease

Assuming this occurred immediately after the first example, European shareholders in the company experienced a (43.50 - 50) / 50 = -13% return, but American holders of the ADR experienced a (15.95 - 21.5093) / 21.5093 = -25.9% return. The currency shock was the primary cause of this magnified loss.

Other points

Another point to keep in mind is that the foreign company itself may be exposed to currency risk if it conducts a lot of business in market with different currencies. Ideally the company has hedged against this, but if you invest in a foreign company through an ADR (or a GDR or another similar instrument), you may take on whatever risk the company hasn't hedged in addition to the currency risk that's present in the ADR/GDR conversion process.

Here are a few articles that discuss currency risk specifically in the context of ADR's: (1), (2). Nestle, a Swiss company that is traded on US exchanges through an ADR, even addresses this issue in their FAQ for investors.

There are other risks associated with instruments like ADR's and cross-listed companies, but normally arbitrageurs will remove these discontinuities quickly. Especially for cross-listed companies, this should keep the prices of highly liquid securities relatively synchronized.

  • Really good but one question. You state that "I'm still taking on currency risk because the ADR is designed to match the performance of the Japanese company's shares trading on a Japanese exchange.". If the ADR was doing this then there would be no currency risk since it would be mimicking the return experienced by a Japanese investor and it would not be mimicking the return experienced by a US investor who has to translate to USD at the end of the holding period. – Jase May 23 '13 at 13:41
  • @Jase Thanks for pointing that out; see my updated answer. I wasn't entirely clear on that point, so I tried to clarify it a bit. Also, it's good to wait a couple of days before accepting an answer in case other people have better answers or provide feedback on my answer (as you just did). – John Bensin May 23 '13 at 13:46
  • Thanks for that. What about something like the company Apple that is directly listed on country B's exchange (where country A is defined as the U.S.); would residents of country B be exposed to the USD/Domestic exchange rate in this transaction? – Jase May 23 '13 at 13:58
  • @Jase I believe so. In the case of Apple, it trades on the Frankfurt Stock Exchange under the ticker APC with a price (as of now) of 339.50 EUR, which is quite close to the US price of 440.53 if you account for the exchange rate. I assume that the market would take into account the exchange rate when pricing Apple in Frankfurt, so it should match fairly closely, but currency risk is still present. – John Bensin May 23 '13 at 14:06
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    +1 ...and the award for 'best use of multiple images in an answer' goes to... nice work, John. – JTP - Apologise to Monica May 23 '13 at 15:56

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