CFA Level I · CFA Level I Exam · Equity Instrument Features
An American depository receipt (ADR) represents 4 ordinary shares of a UK company. The shares trade at £5.00 in London, and the exchange rate is $1.30 per £1. The ADR trades at $26.40 in New York. Ignoring costs, the arbitrage-free ADR price is $26.00. The most appropriate action to exploit the discrepancy is to:
The arbitrageur should buy the shares in London and sell the ADR in New York. Four shares at £5.00 and $1.30 per pound are worth $26.00, while the ADR trades at $26.40, so the ADR is overpriced relative to its underlying shares.
- Abuy the ADR in New York and sell the shares in London
- Bbuy the shares in London and sell the ADR in New YorkCorrect
- Cbuy both the ADR and the shares and hold them
Explanation
Underlying value is 4 × £5.00 × 1.30 = $26.00. The ADR at $26.40 is overpriced by $0.40, so the arbitrageur buys the cheaper shares in London and sells the ADR. Buying the ADR would be the mistaken direction.
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