ADR Premium and the Limits of Arbitrage
A London-listed semiconductor company trades at 418p per ordinary share. Its sponsored Level II ADR (one ADR represents two ordinary shares) is quoted at $11.10 in New York. GBP/USD is 1.2470. The company has declared an interim dividend of 9.5p per ordinary share, payable in three weeks; the ADR depositary charges $0.02 per ADR on dividends and the UK applies no withholding tax at source. Your fund holds 4.5 million ordinary shares. The ADR has traded at a 3–8% premium for six weeks. Your prime broker can lend you ordinary shares at 2.1% annualised and can execute a depositary conversion in five business days at a cost of 12 bp of notional, with a $2,500 fixed fee. The ADR is on the broker's hard-to-borrow list, borrow fee 9.5% annualised. The fund's mandate limits single-stock exposure to 5% of a €450 million NAV, and the position is currently at 4.88%. GBP/EUR is 1.1700. A colleague suggests buying more ADRs because 'the premium is free money'.
1. Calculate the theoretical ADR price and implied premium, quantify the gross and net arbitrage spread on 200,000 ordinary shares, and determine whether the fund can add that position within its mandate.
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Step 1 - theoretical ADR value. One ADR is worth 2 × £4.18 = £8.36. At GBP/USD 1.2470 that is £8.36 × 1.2470 = $10.4249. The quoted ADR price of $11.10 implies a premium of ($11.10 − $10.4249) / $10.4249 = 6.48%. The declared dividend adds 2 × 9.5p = 19p per ADR, or $0.2369, less the $0.02 depositary fee, so it does not explain the premium.
Step 2 - conversion economics. 200,000 ordinary shares produce 100,000 ADRs. Buy cost: 200,000 × £4.18 = £836,000 = $1,042,492. Sell proceeds: 100,000 × $11.10 = $1,110,000. Gross spread = $67,508. Conversion cost: 12 bp × $1,110,000 = $1,332 plus $2,500 = $3,832. If the ADR is shorted first, five days' borrow at 9.5% on $1.11m = $1,444. Net spread ≈ $62,232, or about 5.97% of the ordinary cost, before FX and price risk.
Step 3 - mandate. Current position: 4.5m × £4.18 = £18.81m × 1.1700 = €22.01m, or 4.89% of €450m. Headroom to 5% is €0.49m. The extra 200,000 shares cost £836,000 = €0.978m, taking exposure to 5.11%. The fund cannot add the position without a mandate breach or prior approval.
2. Explain why the ADR premium may persist and identify the risks that make the arbitrage less attractive than it appears.
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The premium can persist because the arbitrage is neither riskless nor costless. Conversion capacity is limited by the depositary and by the supply of ordinary shares; the ADR can attract a separate US retail or index-driven demand base. The five-day conversion exposes the arbitrageur to price and FX moves. Borrow is expensive at 9.5% and the ADR is hard-to-borrow, so shorting the ADR first is costly. Depositary fees, dividend timing (the ADR holder may receive the dividend later), and the 12 bp plus $2,500 conversion cost erode the spread. Regulatory limits such as ADR facility caps or foreign ownership limits can keep the premium in place. A 6.48% premium is close to the all-in cost and risk, so it is not 'free money'.
3. The compliance officer asks whether converting existing ordinary shares into ADRs changes the fund's investment strategy or creates a disclosure issue. Advise.
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Converting existing ordinary shares does not change the fund's economic exposure: the ADR is backed by the same ordinary shares and the currency exposure remains GBP-based, with USD quotation. It is therefore not a strategy change, but it does change the legal form and the custodian/depositary chain. The fund should check: (i) whether the ADR facility permits conversion and whether the shares are eligible; (ii) disclosure thresholds - beneficial ownership generally remains with the fund even if the depositary holds legal title, so transparency notifications should be calculated on the underlying ordinary shares; (iii) securities lending and voting arrangements, because the depositary may vote the shares; (iv) tax treatment of the ADR dividend and depositary fees. Compliance should pre-approve the conversion and document the rationale.