How does arbitrage work with depositary receipts, and what keeps ADR prices aligned with the underlying shares?

Depositary receipts (DRs) — such as American Depositary Receipts (ADRs) — represent shares of a foreign company held by a depositary bank. Arbitrage ensures the ADR price stays close to the price of the underlying foreign shares, adjusted for the exchange rate and the DR ratio.

The Arbitrage Mechanism:

Suppose Matsuyama Electronics trades on the Tokyo Stock Exchange at JPY 5,000 per share, and its ADR trades on the NYSE with a 1:2 ratio (1 ADR = 2 Japanese shares). The USD/JPY rate is 150.

• Fair value of 1 ADR = 2 x JPY 5,000 / 150 = $66.67

Scenario A — ADR trades at a premium ($70):

1. Arbitrageur buys 2 shares in Tokyo for JPY 10,000 ($66.67)
2. Deposits shares with the depositary bank
3. Depositary bank issues 1 new ADR
4. Sell the ADR on NYSE for $70
5. Profit = $70 - $66.67 = $3.33 (before costs)

This selling pressure pushes the ADR price down toward fair value.

Scenario B — ADR trades at a discount ($63):

1. Buy 1 ADR on NYSE for $63
2. Surrender ADR to depositary bank for 2 underlying shares
3. Sell 2 shares in Tokyo for JPY 10,000 ($66.67)
4. Profit = $66.67 - $63 = $3.67 (before costs)

Frictions That Prevent Perfect Alignment:

• Time zone gaps: Tokyo and NYSE don't overlap, creating windows where arbitrage cannot execute simultaneously
• Transaction costs: Depositary fees, brokerage, FX conversion costs
• Capital controls: Some countries restrict foreign ownership or currency conversion
• Tax withholding: Different dividend tax treaties affect total return
• Settlement timing: Different markets have different settlement cycles (T+1 vs T+2)

Exam Relevance: CFA questions may present a DR price, underlying price, and exchange rate and ask you to calculate the premium/discount and describe the arbitrage trade.

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