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than they need (because they save some of their income) transfer those funds to people, companies, or governments who have a shortage of funds (because they spend more than their income). Stock and bond markets are two major capital markets. Capital markets promote economic efficiency by channelling money from those who do not have an immediate productive use for it to those who do. Capital markets carry out the desirable economic function of directing capital to productive uses. The savers (governments, businesses, and people who save some portion of their income) invest their money in capital markets like stocks and bonds. The borrowers (governments, businesses, and people who spend more than their income) borrow the savers' investments that have been entrusted to the capital markets. For example, suppose A and B make Rs. 50,000 in one year, but they only spend Rs.40,000 that year. They can invest the 10,000 - their savings - in a mutual fund investing in stocks and bonds all over the world. They know that making such an investment is riskier than keeping the 10,000 at home or in a savings account. But they hope that over the long-term the investment will yield greater returns than cash holdings or interest on a savings account. The borrowers in this example are the companies that issued the stocks or bonds that are part of the mutual fund portfolio. Because the companies have spending needs that exceeds their income, they finance their spending needs by issuing securities in the capital markets.
The Structure of Capital Markets Primary markets: The primary market is where new securities (stocks and bonds are the most common) are issued. The corporation or government agency that needs funds (the borrower) issues securities to purchasers in the primary market. Big investment banks assist in this issuing process. The banks underwrite the securities. That is, they guarantee a minimum price for a business's securities and sell them to the public. Since the primary market is limited to issuing new securities only, it is of lesser importance than the secondary market. Secondary market: The vast majority of capital transactions, take place in the secondary market. The secondary market includes stock exchanges (like the New York Stock Exchange and the Tokyo Nikkei), bond markets, and futures and options markets, among others. All of these secondary markets deal in the trade of securities. Securities: The term "securities" encompasses a broad range of investment instruments. Investors have essentially two broad categories of securities available to them: 1. Equity securities (which represent ownership of a part of a company) 2. Debt securities (which represent a loan from the investor to a company or government entity). Equity securities: Stock is the type of equity security with which most people are familiar. When investors (savers) buy stock, they become owners of a "share" of a company's assets and earnings. If a company is successful, the price that investors are willing to pay for its stock will often rise and shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. Stock prices are also subject to both general economic and industry-specific market factors. In our example, if Carlos and Anna put their money in stocks, they are buying equity in the company that issued the stock. Conversely, the company can issue stock to obtain extra funds. It must then share its cash flows with the stock purchasers, known as stockholders.
Debt securities: Savers who purchase debt instruments are creditors. Creditors, or debt holders, receive future income or assets in return for their investment. The most common example of a debt instrument is a bond. When investors buy bonds, they are lending the issuers of the bonds their money. In return, they will receive interest payments (usually at a fixed rate) for the life of the bond and receive the principal when the bond expires. National governments, local governments, water districts, global, national, and local companies, and many other types of institutions sell bonds. Internationalization of Capital Markets in the Late 1990s One of the most important developments since the 1970s has been the internationalization, and now globalization, of capital markets. Let's look at some of the basic elements of the international capital markets. 1. The International Capital Market of the Late 1990s was composed of a Number of Closely Integrated Markets with an International Dimension: Basically, the international capital market includes any transaction with an international dimension. It is not really a single market but a number of closely integrated markets that include some type of international component. The foreign exchange market was a very important part of the international capital market during the late 1990s. Internationally traded stocks and bonds have also been part of the international capital market. Since the late 1990s, sophisticated communications systems have allowed people all over the world to conduct business from wherever they are. The major world financial centres include Hong Kong, Singapore, Tokyo, London, New York, and Paris, among others. Foreign bonds are a typical example of an international security. A bond sold by a Korean company in Mexico denominated in Mexican pesos is a foreign bond. Eurobonds are another example. Of course, the foreign exchange market, where international currencies are traded, was a tremendously large and important part of the international capital market in the late 1990s.
2. The Need to Reduce Risk Through Portfolio Diversification Explains in Part the Importance of the International Capital Market During the Late 1990s: A major benefit of the internationalization of capital markets is the diversification of risk. Individual investors, major corporations, and individual countries all usually try to diversify the risks of their financial portfolios. The reason is that people are generally risk-averse. They would rather get returns on investments that are in a relatively narrow band than investments that have wild fluctuations year-to-year. All portfolio investors look at the risk of their portfolios versus their returns. Higher risk investments generally have the potential to yield higher returns, but there is much more variability.
Here is an example: Suppose Corporation XYZ in 1996 had the following portfolio:
1000 shares of Japanese utility company stock; 1000 shares of Mexican petroleum company stock; German government bonds valued at 8000 deutsche marks (today
1000 shares of a Moroccan mutual fund; Canadian municipal bonds valued at 8000 Canadian dollars.
Suppose Corporation ABC in 1996 had the following portfolio:
10,000 shares of Swedish steel company.
If the steel company in Sweden has a poor year for sales and profits, its stock value decreases. Corporation ABC, which has not diversified, will have a terrible return on its portfolio. The next year, the steel company may have a great year, so ABC will have a terrific portfolio return. Corporation XYZ, with a diversified portfolio, can overcome a single poor return and still have a good overall return on the portfolio. If utilities in Japan have a poor year, but Morocco is experiencing strong economic growth, the Moroccan gain can offset the Japanese stock loss. Then, the next year, perhaps the reverse would occur (Morocco experiences a slowdown while the Japanese
utility realizes higher profits than anticipated). The year-to-year return would fluctuate much less for Corporation XYZ than for ABC. 3. The Principal Actors in the International Capital Markets of the Late 1990s were Banks, Non-Bank Financial Institutions, Corporations, and Government Agencies: Commercial banks powered their way to a place of considerable influence in international markets during the late 1990s. Commercial banks undertook a broad array of financial activities during the late 1990s. They granted loans to corporations and governments, were active in the bond market, and held deposits with maturities of varying lengths. Special asset transactions, like underwriting were undertaken by commercial banks. Non-bank financial institutions became another fast-rising force in international markets during the late 1990s. Insurance companies, pension and trust funds, and mutual funds from many countries began to diversify into international markets in the 1990s. Together, portfolio enhancement and a widespread increase in fund contributors have accounted for the strength these funds had in the international marketplace. Government agencies, including central banks, were also major players in the international marketplace during the late 1990s. Central banks and other government agencies borrowed funds from abroad. Governments of developing countries borrowed from commercial banks, and state-run enterprises also obtained loans from foreign commercial banks. 4. Changes in the International Marketplace Resulted in a New Era of Global Capital Markets during the Late 1990s, which were Critical to Development. Many observers say we entered an era of global capital markets in the 1990s. The process was attributable to the existence of offshore markets, which came into existence decades prior because corporations and investors wanted to escape domestic regulation. The existence of offshore markets in turn forced countries to liberalize their domestic markets (for competitive reasons). This dynamic created greater internationalization of the capital markets. Three primary reasons account for this phenomenon. First, citizens around the world (and especially the Japanese) began to increase their personal savings. Second, many governments further deregulated their capital markets since 1980. This allowed domestic companies more opportunities abroad, and foreign companies had the opportunity to invest in the deregulated countries. Finally, technological advances made it easier to access global markets. Information could be retrieved quicker, easier, and cheaper than ever before.
Developing countries, like all countries, must encourage productive investments to promote economic growth. Thus, foreign savings, which many people simply call foreign investment, can benefit developing countries. In Indian context: The international capital market as it has been evolving provides an opportunity for developing countries like India to attract the required capital inflow for accelerating their pace of development, manage their foreign exchange assets and liabilities to their advantage and develop export capabilities in the field of financial services. Active participation in this market would not only improve their access to the market but also indicate the institutional and policy framework essential for developing effective and efficient domestic financial markets. The possibilities of such participation would be enhanced if the developing countries like India take a constructive stand with regard to the multilateral negotiations in respect of trade in services under the Uruguay Round. Recent situation Recent financial problems in emerging economies have led to calls for a new international financial architecture. Some of the problems are: 1. Inflation concerns are increasingly taking hold of the international capital markets; there are fears of a repetition of the 1970s, when industrialized countries endured double-digit rates of inflation. 2. Higher energy and food prices, rising wages in emerging markets and the weak US dollar which is driving up US import prices. 3. In emerging markets like India inflation is being driven above all by rising food prices. 4. In recent months oil has breached the 130 US dollar per barrel mark, and thus been a main driver of global inflationary pressure. Declining reserves in the oilproducing countries, and low levels of investment and political problems could tighten the supply situation still further, countering any efforts to improve energy efficiency and further develop alternative energy sources. Production will not be able to keep pace with growing demand, especially from Asia. So the oil price is likely to remain high and continue rising in the long term." 5. Still it is believed that there may not be a recession in the USA, but a there may not be a quick recovery either. In the Euro zone we are likely to see a cooling-off of the economy in 2008 and 2009. Emerging markets should be able to decouple further from the US economy and consolidate their growth at a high level.
In the above conditions, International capital flows should not be restricted; they benefit entrepreneurs and savers alike, with lower borrowing costs and greater returns. The international flow of capital improves risk management, allows consumption smoothing, improves financial-sector efficiency, and leads to greater overall market discipline. Furthermore, capital flows have a stabilizing effect on financial markets. Restricting international investment denies a country those benefits; the result is slower growth and reduced standards of living. Importance of capital market: 1. The capital market serves as an important source for the productive use of economy’s savings. It mobilizes the saving of the people for further investment and thus avoids their wastage in unproductive uses. 2. It provides incentives to saving and facilitates capital formation by offering suitable rates of interest as the price of capital. 3. It provides an avenue for investors, particularly the household sector to invest in financial assets which are more productive than physical assets. 4. It facilitates increase in production and productivity in the economy and thus, enhances the economic welfare of the society. Thus it facilitates “the movement of stream of command over capital to the point of highest yield” towards those who can apply them productively and profitably to enhance the national income in the aggregate. 5. The operations of different institutions in the capital market induce economic growth. They give quantitative and qualitative directions to the flow of funds and bring about rational allocation of scarce resources. 6. A healthy capital market consisting of expert intermediaries promotes stability in values of securities representing capital funds. 7. Moreover, it serves as an important source for technological up gradation in the industrial sector by utilizing the funds invested by the public. Thus, a capital market serves as an important link between those who save and those who aspire to invest their savings.
DRAWBACKS OF FOREIGN CAPITAL 1) Foreign capital usually does not produce an efficient because of the microeconomic distortions and macro economics instability it generates. In fact it has been found that the increasing volume of international financial flows has been associated with a decline in the trade volume due to higher costs. 2) Another harmful impact of these flows has been to increase the instability of volatility in the exchange rates, assets prices, interest rates and the whole economical system of the recipient countries. 3) The global capital flows reduce the effectiveness of monetary policy they are associated with the loss of monetary control at home. The current surge in these flows has created a major worry for the regulatory authorities about the global money. 4) The cost of foreign is rather difficult to measure and it is subject to a great variability. Foreign currency borrowings imply a series of uncertainties due to floating interest and vary margins. This is an important reason for exercising utmost restraint while seeking to raise funds abroad. 5) The non economical costs of the foreign capital are also unaffordable. It is well known but conveniently forgotten that the foreign capital creates a larger number of very serious problems of foreign ownership and control dumping of technology loss of autonomy of domestic policies dependence hegemony and neo-colonialism. 6) The existence of a contrary belief notwithstanding the foreign capital is not nor free the costs and harmful effects discussed above. In fact the relevance of what has just been said is all the greater in its case. 7) The debt capital has its own problems expressions like debt trap debt crisis debt bomb are now commonly used to convey the dangerous situation in which the developing countries land themselves when they depend in the foreign debt capital.
CAPITAL MARKET IN INDIA: Coming to Indian context, the term capital market refers to only stock markets as per the common man's ideology, but the capital markets have a much broader sense. Where as in global scenario, it consists of various markets such as: 1. Government securities market 2. Municipal bond market 3. Corporate debt market 4. Stock market 5. Depository receipts market 6. Mortgage and asset-backed securities market 7. Financial derivates market 8. Foreign exchange market India’s presence in International Markets: India has made its presence felt in the IFMs only after 1991-92. At present there are over 50 companies in India, which have accessed the GDR route for raising finance. The change in situation has been due to the following factors: 1. Improved perception of India’s economic reforms. 2. Improved export performance. 3. Healthy economic indicator. 4. Inflation at single digit. 5. Improved forex reserves. 6. Improved performance of Indian companies. 7. Improved confidence of FIIs. Reliance was the first Indian company to issue GDR in 1992. Since 1993, number of Indian companies successfully tapped the global capital markets & raised capital through GDR or foreign currency bond issues. Though there was a temporary setback due to Asian crisis in 1997. Since 1999 even IT majors have stepped the bandwagon of international markets & raised capital. The average size of the issue was around 75USD. And the total amount raised was around USD 6.5billion. India has the distinction of having the largest number of GDR/ADR issues by any country. INTERMEDIARIES INVOLVED IN INTERNATIONAL CAPITAL MARKET: Lead & co-lead managers: The responsibilities of a lead manager include undertaking due diligence & preparing the offered document , marketing the issues , arrangement & conducting road shows. Mandate is given by the issuer to the lead manager.
Underwriters: The lead manager & co managers act as underwriters to the issue , taking on the risk of interest rates /markets moving against them before they have placed bonds/DRs. Lead Managers may also invite additional investment banks to act as sub-underwriters , thus forming a larger underwriting group. The underwriters undertake to subscribe to the unsubscribed portion of the issue . Agents & Trustees: These intermediaries are involved in the issue of bonds/convertibles. The issuer of bonds convertible in association with the lead manager must appoint ‘paying agents’ in different fifnacial centers, who will arrange for the payment of interest & principal due to investor under the terms of the issue. These paying agents will be banks. Lawyers & Auditors: The lead manager will appoint a prominenet firm of solicitors to draw up documentation evidencing the bond/DRs issue. The various draft documents will vetted by the solicictors acting for the issuer. Many of these documents are prepared in standard forms with a careful review to the satisfaction of the parties. The legal advisors will advise the issuer pertaining to the local & foreign laws. Similarly, Auditors are required for preparation of the financial statements, cash flows, and audit reports. The Auditors provide a comfort letter to the lead manager on the financial health of the company. They also prepare the financial statement as per GAAP requirements wherever necessary. Listing Agents & Stock Exchanges: The listing Agent helps facilitate the documentation & listing process for listing on stock exchange & keep file information regarding the issuer such as Annual reports, depository agreements, articles of association,etc. The stock exchange reviews the issuers application for listing of bonds/GDRs & provides comments on offering circular prior to accepting the security for listing. Depository Bank: It is involved only in the issue of GDRs. It is responsible for issuing the actual GDRs ,disseminating information from the issuer to the DR holders, paying any dividends or other distributions & facilitating the exchange of GDRs into underlying shares when presented for redemption. Custodian: The Custodian holds the shares underlying the GDRs on behalf of the depository &is responsible for collecting rupee dividends on the underlying shares & repatriation of the same to the depository in US dollars/foreign currency.
Sources of Capital There are two sources of capital: 1. Private sources 2. Public sources Both sources are very important to the economies of the world. Capital flows result when funds are transferred across borders; the flows are recorded in the balance of payments account. Read on for definitions, examples, and trends in capital flows.
1. Private Sources of Capital. Important sources of private capital are a. Foreign direct investment b. Portfolio investment (both debt and equity flows) Each is defined below. a. Foreign Direct Investment (FDI): Foreign direct investment is capital invested by corporations in countries other than their places of domicile (their home countries). Direct investment is not nearly as liquid as portfolio investment and is therefore less volatile. The normal requirement to qualify as foreign direct investment is for the foreign firm to own at least ten percent of voting stock. An example of foreign direct investment is a Japanese company that starts a joint venture (50-50) in Mexico with a Mexican company. The Japanese company has a long-term investment in the assets of the joint venture and not merely a passive investment like portfolio investors, who can remove their money from a country almost instantaneously. FDI or Foreign Direct Investment is any form of investment that earns interest in enterprises which function outside of the domestic territory of the investor. FDIs require a business relationship between a parent company and its foreign subsidiary. Foreign direct business relationships give rise to multinational corporations. For an investment to be regarded as an FDI, the parent firm needs to have at least 10% of the ordinary shares of its foreign affiliates. The investing firm may also qualify for an FDI if it owns voting power in a business enterprise operating in a foreign country.
Types of Foreign Direct Investment: An Overview FDIs can be broadly classified into two types: 1. Outward FDIs 2. Inward FDIs. This classification is based on the types of restrictions imposed, and the various prerequisites required for these investments. An outward-bound FDI is backed by the government against all types of associated risks. This form of FDI is subject to tax incentives as well as disincentives of various forms. Risk coverage provided to the domestic industries and subsidies granted to the local firms stand in the way of outward FDIs, which are also known as “direct investments abroad.” Different economic factors encourage inward FDIs. These include interest loans, tax breaks, grants, subsidies, and the removal of restrictions and limitations. Factors detrimental to the growth of FDIs include necessities of differential performance and limitations related with ownership patterns. Other categorizations of FDI exist as well. Vertical Foreign Direct Investment takes place when a multinational corporation owns some shares of a foreign enterprise, which supplies input for it or uses the output produced by the MNC. Horizontal foreign direct investments happen when a multinational company carries out a similar business operation in different nations. Foreign Direct Investment is guided by different motives. FDIs that are undertaken to strengthen the existing market structure or explore the opportunities of new markets can be called “market-seeking FDIs.” “Resource-seeking FDIs” are aimed at factors of production which have more operational efficiency than those available in the home country of the investor. Some foreign direct investments involve the transfer of strategic assets. FDI activities may also be carried out to ensure optimization of available opportunities and economies of scale. In this case, the foreign direct investment is termed as “efficiency-seeking.”
Benefits of FDIs: One of the advantages of foreign direct investment is that it helps in the economic development of the particular country where the investment is being made. This is especially applicable for the economically developing countries. During the decade of the 90s foreign direct investment was one of the major external sources of financing for most of the countries that were growing from an economic perspective. It was observed during the financial problems of 1997-98 that the amount of foreign direct investment made in these countries was pretty steady. The other forms of cash inflows in a country like debt flows and portfolio equity had suffered major setbacks. Foreign direct investment also permits the transfer of technologies. This is done basically in the way of provision of capital inputs. It also assists in the promotion of the competition within the local input market of a country. The countries that get foreign direct investment from another country can also develop the human capital resources by getting their employees to receive training on the operations of a particular business. Foreign direct investment helps in the creation of new jobs in a particular country. It also helps in increasing the salaries of the workers. This enables them to get access to a better lifestyle and more facilities in life. Foreign direct investment assists in increasing the income that is generated through revenues realized through taxation. It also plays a crucial role in the context of rise in the productivity of the host countries. It also opens up the export window that allows these countries the opportunity to cash in on their superior technological resources. It has been possible for the recipient countries to keep their rates of interest at a lower level. It becomes easier for the business entities to borrow finance at lesser rates of interest. The biggest beneficiaries of these facilities are the small and medium-sized business enterprises.
Disadvantages of Foreign Direct Investment The disadvantages of foreign direct investment occur mostly in case of matters related to operation, distribution of the profits made on the investment and the personnel. The situations in countries like Ireland, Singapore, Chile and China corroborate such an opinion. It is normally the responsibility of the host country to limit the extent of impact that may be made by the foreign direct investment. They should be making sure that the entities that are making the foreign direct investment in their country adhere to the environmental, governance and social regulations that have been laid down in the country. The various disadvantages of foreign direct investment are understood where the host country has some sort of national secret – something that is not meant to be disclosed to the rest of the world like defense. At times it has been observed that certain foreign policies are adopted that are not appreciated by the workers of the recipient country. Foreign direct investment may entail high travel and communications expenses. The differences of language and culture could also pose problems in case of foreign direct investment. Yet another major disadvantage of foreign direct investment is that there is a chance that a company may lose out on its ownership to an overseas company. At times it has been observed that the governments of the host country are facing problems with foreign direct investment. It has less control over the functioning of the company that is functioning as the wholly owned subsidiary of an overseas company. This leads to serious issues. The investor does not have to be completely obedient to the economic policies of the country where they have invested the money. At times there have been adverse effects of foreign direct investment on the balance of payments of a country.
Foreign Institutional Investors (FII) : FII means an entity established or incorporated outside India which proposes to make investment in India. An investor or investment fund that is from or registered in a country outside of the one in which it is currently investing. Institutional investors include hedge funds, insurance companies, pension funds and mutual funds. In countries like India, statutory agencies like SEBI have prescribed norms to register FIIs and also to regulate such investments flowing in through FIIs. FEMA norms includes maintenance of highly rated bonds (collateral) with security exchange.
Following entities / funds are eligible to get registered as FII: 1. Pension Funds 2. Mutual Funds 3. Insurance Companies 4. Investment Trusts 5. Banks 6. University Funds 7. Endowments 8. Foundations 9. Charitable Trusts / Charitable Societies
Further, following entities proposing to invest on behalf of broad based funds, are also eligible to be registered as FIIs: 1. Asset Management Companies 2. Institutional Portfolio Managers 3. Trustees 4. Power of Attorney Holders
Parameters on which SEBI decides FII applicants’ eligibility a. Applicant’s track record, professional competence, financial soundness, experience, general reputation of fairness and integrity. (The applicant should have been in existence for at least one year) b. whether the applicant is registered with and regulated by an appropriate Foreign Regulatory Authority in the same capacity in which the application is filed with SEBI c. Whether the applicant is a fit & proper person.
b. Portfolio investment: debt flows and equity flows. Portfolio debt flows result from foreign investors buying domestic debt securities. A German investor buying bonds in Canada is an example. Commercial bank lending (loans from private financial institutions) is also portfolio debt. Portfolio equity flows occur, similarly, when foreign investors purchase equity securities domestically. A Japanese investor who purchases stock in the Brazilian stock market is creating an equity capital flow into Brazil. ADRs and GDRs also fit into this category.
FDI V/S FII” Motive FDI Motive behind FDI is to acquire controlling interest in a foreign entity or set up an entity with controlling interest. FDI investment comes from MNC’s and corporate so as to derive benefit of new market, cheaper resources (labor), efficiency and skills, strategic asset seeking (oil fields) and time geography (BPO – Transcriptions) FDI investment is more enduring and has longer time stability. FDI generally comes as subsidiary or a joint venture. FDI is made with core thought of business philosophy of diversification, integration, consolidation, and expansion and/or core business formation. Calculation of gains is always prime criteria but never the sole criteria. FII Motive behind FII is to make (capital) gains from investments. There is no intention to control the entity. FII investment come from investors, mutual funds, portfolio management companies and corporate with pure motive of investment gains. FII is highly volatile. FII comes mainly through stock markets. FII’s sole criteria and motive is gains on investments.
Duration Form Purpose
2. Public Sources of Capital. Public sources of capital include a. Official non-concessional loans of both multilateral and bilateral aid b. Official development assistance (ODA). Each is discussed in turn below.
a. Official non-concessional loans: multilateral & bilateral aid. Official non-concessional multilateral aid consists of loans from the World Bank, regional development banks, and other intergovernmental agencies such as multilateral organizations. The term "non-concessional" refers to the fact that these loans are based on market rates, must be repaid, and are not partly grants. By contrast, official non-concessional bilateral aid is loans from governments and their central banks or other agencies. Export credit agency loans are also included here. "Bilateral" refers to the fact that the entities providing the funding provide aid only in their home country.
b. ODA: official grants and concessional loans. ODA refers in part to official public grants that are legally binding commitments and provide a specific amount of capital available to disburse (give out) for which no repayment is required. Concessional bilateral aid refers to aid from governments, central banks, and export credit agencies that contains a partial grant element (25% or more), or partially forgives the loan. Similarly, concessional multilateral aid contains a partial grant, or forgiveness of the loan. Multilateral aid comes from the World Bank, regional development banks and intergovernmental agencies.
Instruments in capital markets
Instruments in International Capital Markets:
International Bond Market
International Equity Markets
International Equity Markets: Funds can be raised in the primary market from the domestic market as well as from international markets. After the reforms were initiated in 1991, one of the major policy changes was allowing Indian companies to raise resources by way of equity issues in the international markets. Earlier, only debt was allowed to be raised from international markets. In the early 1990s foreign exchange reserves had depleted and the country’s rating had been downgraded. This resulted in a foreign exchange crunch and the government was unable to meet the import requirement of Indian companies. Hence allowing companies to tap the equity and bond market In Europe seemed a more sensible option. This permission encourages Indian companies to become global. India companies have raised resources from international capital markets through 1. Global depository receipts (GDRs) / 2. American Depository Receipts (ADRs) 3. Foreign Currency Convertible Bonds (FCCBs) 4. External Commercial Borrowings (ECBs). Depository Receipts (GDRs and ADRs) “Global Depositary Receipts mean any instrument in the form of a depositary receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares or Foreign Currency Convertible Bonds of issuing company.” A GDR issued in America is an American Depositary Receipt (ADR). Issue of equity in the form of GDR/ADR is possible only for the few top notch corporates of the country. Among the Indian companies, Reliance Industries Limited was the first company to raise funds through a GDR issue. Introduction: ADR stands for American Depository Receipt. Similarly, GDR stands for Global Depository Receipt. Every publicly traded company issues shares – and these shares are listed and traded on various stock exchanges. Thus, companies in India issue shares which are traded on Indian stock exchanges like BSE (The Stock Exchange, Mumbai), NSE (National Stock Exchange), etc. These shares are sometimes also listed and traded on foreign stock exchanges like NYSE (New York Stock Exchange) or NASDAQ (National Association of Securities Dealers Automated Quotation).But to list on a foreign stock exchange, the company has to comply with the policies of those stock exchanges.
Many times, the policies of these exchanges in US or Europe are much more stringent than the policies of the exchanges in India. This deters these companies from listing on foreign stock exchanges directly. But many good companies get listed on these stock exchanges indirectly – using ADRs and GDRs. Process of issue of ADR/GDR: 1. The company deposits a large number of its shares with a bank located in the country where it wants to list indirectly. The bank issues receipts against these shares, each receipt having a fixed number of shares as an underlying (Usually 2 or 4). 2. These receipts are then sold to the people of this foreign country (and anyone who are allowed to buy shares in that country). These receipts are listed on the stock exchanges. 3. They behave exactly like regular stocks – their prices fluctuate depending on their demand and supply, and depending on the fundamentals of the underlying company. 4. These receipts, which are traded like ordinary stocks, are called Depository Receipts. Each receipt amounts to a claim on the predefined number of shares of that company. The issuing bank acts as a depository for these shares – that is, it stores the shares on behalf of the receipt holders.
1. ADR - American Depositary Receipt Definitions: It is a receipt for shares bought in the US of a foreign-based corporation in an overseas market. The receipt is held by a US bank, but shareholders are entitled to any dividends and capital gains. Security representing the ownership interest in a foreign company's common stock. ADRs allow foreign shares to be traded in the United States Certificates issued by a US depository bank, representing foreign shares held by the bank, usually by a branch or correspondent in the country of issue. One ADR may represent a portion of a foreign share, one share or a bundle of shares of a foreign corporation.
Meaning: American Depository Receipts (ADRs) are certificates that represent shares of a foreign stock owned and issued by a U.S. bank. The foreign shares are usually held in custody overseas, but the certificates trade in the U.S. Through this system, a large number of foreign-based companies are actively traded on one of the three major U.S. equity markets (the NYSE, AMEX or Nasdaq). An American Depositary Receipt (ADR) is how the stock of most foreign companies trades in United States stock markets. Each ADR is issued by a U.S. depositary bank and represents one or more shares of a foreign stock or a fraction of a share. If investors own an ADR they have the right to obtain the foreign stock it represents, but U.S. investors usually find it more convenient to own the ADR. The price of an ADR is often close to the price of the foreign stock in its home market, adjusted for the ratio of ADRs to foreign company shares.
Depository banks have numerous responsibilities to the holders of ADRs and to the non-U.S. company the ADRs represent. The largest depositary bank is The Bank of New York. Individual shares of a foreign corporation represented by an ADR are called American Depositary Shares (ADS). Pricing of ADR: The prices of ADRs in the secondary market are, of course, determined by supply and demand, but the price will not deviate too much from the price of the underlying stock. If the ADR is trading at a higher price than the equivalent foreign shares of the company, then more shares of the company will be bought and held in the custodian bank, and more ADRs will be created. If the ADR
trades below the equivalent price, then some ADRs will be canceled, and the corresponding shares of the company will be released by the custodian bank. This maintains parity between the price of the ADR and the foreign shares, after accounting for the currency exchange rate. Dividend payments: When dividends are paid, the custodian bank receives it and withholds any foreign taxes, exchanges it for U.S. dollars, then sends it to the depositary bank, which then sends it to the investors. The depositary bank, being a U.S. bank, handles most of the interaction with the U.S. investors, such as rights offerings, stock splits, and stock dividends, but sponsored ADR investors may receive communications, such as financial statements, directly from the company. Risks involved: Although ADR transactions are in U.S. currency, there still is a currency exchange risk. If the dollar falls, for instance, then the amount of dividend in U.S. dollars will be reduced, and the market price of the ADR will drop. There is also political risk because the ADR still derives its value from the foreign stock, which could be adversely affected by unfavorable changes in politics or the law of the country. How It Works/Example: Investors can purchase ADRs from broker/dealers. These broker/dealers in turn can obtain ADRs for their clients in one of two ways: they can purchase alreadyissued ADRs on a U.S. exchange, or they can create new ADRs. To create an ADR, a U.S.-based broker/dealer purchases shares of the issuer in question in the issuer's home market. The U.S. broker/dealer then deposits those shares in a bank in that market. The bank then issues ADRs representing those shares to the broker/dealer's custodian or the broker-dealer itself, which can then apply them to the client's account. A broker/dealer's decision to create new ADRs is largely based on its opinion of the availability of the shares, the pricing and market for the ADRs, and market conditions. Broker/dealers don't always start the ADR creation process, but when they do, it is referred to as an unsponsored ADR program (meaning the foreign company itself has no active role in the creation of the ADRs). By contrast, foreign companies that wish to make their shares available to U.S. investors can initiate what are called sponsored ADR programs. Most ADR programs are sponsored,
as foreign firms often choose to actively create ADRs in an effort to gain access to American markets. ADRs are issued and pay dividends in U.S. dollars, making them a good way for domestic investors to own shares of a foreign company without the complications of currency conversion. However, this does not mean ADRs are without currency risk. Rather, the company pays dividends in its native currency and the issuing bank distributes those dividends in dollars -- net of conversion costs and foreign taxes -- to ADR shareholders. When the exchange rate changes, the value of the dividend changes. For example, let's assume the ADRs of XYZ Company, a French company, pay an annual cash dividend of 3 euros per share. Let's also assume that the exchange rate between the two currencies is even -- meaning one Euro has an equivalent value to one dollar. XYZ Company's dividend payment would therefore equal $3 from the perspective of a U.S. investor. However, if the euro were to suddenly decline in value to an exchange rate of one euro per $0.75, then the dividend payment for ADR investors would effectively fall to $2.25. The reverse is also true. If the euro were to strengthen to $1.50, then XYZ Company's annual dividend payment would be worth $4.50. Levels of ADRs There are three levels of ADRs depending on their adherence to Generally Accepted Accounting Principles
For a Level I ADR program the receipts issued in the US are registered with
the SEC, but the underlying shares are held in the depositary bank are not registered with the SEC. They must partially adhere to Generally Accepted Accounting Principles (GAAP) used in the USA. Level II ADRs are those in which both the ADRs and the underlying shares (that already trade in the foreign company’s domestic market) are registered with the SEC. They must also partially adhere to the Generally Accepted Accounting Principles. Level III ADRs must adhere fully to the GAAP and the underlying shares held at the Depositary Bank are typically new shares not those already trading in the foreign company’s domestic currency.
2. GDRs Global Depository Receipts Definitions: A Global Depository Receipt or Global Depositary Receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign company Global Depository Receipts (GDRs) may be defined as a global finance vehicle that allows an issuer to raise capital simultaneously in two or markets through a global offering. GDRs may be used in public or private markets inside or outside US. GDR, a negotiable certificate usually represents company’s traded equity/debt. The underlying shares correspond to the GDRs in a fixed ratio say 1 GDR=10 shares. Meaning: A Global Depository Receipt or GDR is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares. Global Depository Receipts facilitate trade of shares, and are commonly used to invest in companies from developing or emerging markets - especially RUSSIA. Prices of GDRs are often close to values of related shares, but they are traded and settled independently of the underlying share. Normally 1 GDR = 10 Shares Several international banks issue GDRs, such as JP Morgan Chase, Citigroup, Deutsche Bank, Bank of New York. They trade on the International Order Book (IOB) of the London Stock Exchange. Listing of the Global Depositary Receipts The Global Depository Receipts issued may be listed on any of the Overseas Stock Exchanges, or Over the Counter Exchanges or through Book Entry Transfer Systems prevalent abroad and such receipts may be purchased, possessed and freely transferable Issue structure of the Global Depositary Receipts (1) A Global Depository Receipt may be issued for one or more underlying shares or bonds held with the Domestic Custodian Bank. (2) The Foreign Currency Convertible Bonds and Global Depository Receipts may be denominated in any freely convertible foreign currency. (3) The ordinary shares underlying the Global Depository Receipts and the
shares issued upon conversion of the Foreign Currency Convertible Bonds will be denominated only in Indian currency. (4) The following issue will be decided by the issuing company with the Lead Manager to the issue, namely:(a) Public or private placement; (b) Number of Global Depository Receipts to be issued; (c) The issue price; (d) The rate of interest payable on Foreign Currency Convertible Bonds; and (e) The conversion price, coupon, and the pricing of the conversion options of the Foreign Currency Convertible Bonds. (5) There would be no lock-in-period for the Global Depository Receipts issued under this scheme History of GDRs in India India entered the international arena in May 1992, with the first GDR issue by Reliance Industries Limited, which collected US b$150 million. This was followed by Grasim Industries’ offer of US $90 million in November. Then, the GDR markets witnessed a lull till 1993-end in the wake of the securities scam and the consequent fall in the domestic markets, during which time the only Indian offering came from HINDALCO in July 1993, which raised US $72 million. The end of 1993 saw a flood of Indian paper hit the Euro markets with Bombay Dyeing, Mahindra and Mahindra, SPIC and Sterlite Industries raising funds. This boom continued till mid-1995, after which a combination of factors – political instability, falling markets, reduced profitability due to a liquidity crunch - pulled down the GDR market again, till the end of 1996, during which time, the only notable exception was the US $370 million offering by the State Bank of India. Procedure for an Initial Issue of GDR GDRs are marketed through a syndication process which is the responsibility of lead managers. The lead manager is involved in the issue structuring, pricing and obtaining market feedback on the issue timing. The lead manager also prepares in-depth research and offer documents for circulation to prospective institutional investors. He/she also assists in the selection of the foreign depository, foreign legal advisors and compliance with the listing requirements of the stock exchanges. The steps in Euro issue management in chronological order are as follows:
Pre-issue: Discuss strategy, obtain approvals, obtain legal advice. Prepare tentative plan and size of the issue. Week 0-4: Nominate lead manager. Discuss plan and other roles with lead manager/ co-manager. Depository/bankers/auditors to the issue provide information to the lead manager for drafting of offer documents and agreements. Week 5-7: Meetings between lead managers, legal advisors and auditors and the issuers executives. Preparation of offer circular completed. Week 8: Lead manager completes and sends preliminary offer documents to comanagers and other - underwriters. Week 9: Road shows, investor meets abroad. Lead managers and is seller decide to-send different teams to focus on geographical locations. Agreement documentation finalized after final discussions between concerned parties. Week 10 Launch and syndication by the lead managers and. co-managers. Foreign listing and trading approvals received. Benefits and Uses of a GDR Benefits to an Issuing Company Currently, there are over 1600 Depository Receipt programmes for companies from over 60 countries. Companies have round that the establishment of a depository receipt programme offers numerous advantages. The primary reasons why a company would establish a depository receipt programme can be divided into. the following considerations: Access to capital markets outside the home market to provide a mechanism for raising capital or as a vehicle for an acquisition. Enhancement of company visibility by. enhancement of image of the company’s products, services or financial instruments in a marketplace outside its home country. Expanded shareholder base which may increase or stabilize the share price May increase local share, price as a result of global demand/ trading through a broadened and a more diversified investor exposure. Increase potential liquidity by enlarging the market for the company’s shares. Adjust share price to trading market comparables through Ratio Enhance shareholder communications and enable employees to invest easily in the parent company.
Benefits to an Investor They facilitate diversification into foreign securities.Trade, clear and settle in accordance with requirements of the market in which they trade. Eliminate custody charges. Can be easily compared to securities of similar companies. Permit prompt dividend payments and corporate action notifications. If GDRs are exchange listed, investors also benefit from accessibility of price and trading information and research. In addition to the benefits GDRs have to offer to the issuing company and the investor, they are also increasingly being used by governments to facilitate the process of privatization. They have also been used to raise capital in the process of acquisition of other companies by the issuer. What is the difference between ADR and GDR? Both ADR and GDR are depository receipts, and represent a claim on the underlying shares. The only difference is the location where they are traded.If the depository receipt is traded in the United States of America (USA), it is called an American Depository Receipt, or an ADR. If the depository receipt is traded in a country other than USA, it is called a Global Depository Receipt, or a GDR. While ADRs are listed on the US stock exchanges, the GDRs are usually listed on a European stock exchange.
How can you use an ADR / GDR? ADRs and GDRs are not for investors in India – they can invest directly in the shares of various Indian companies. But the ADRs and GDRs are an excellent means of investment for NRIs and foreign nationals wanting to invest in India. By buying these, they can invest directly in Indian companies without going through the hassle of understanding the rules and working of the Indian financial market – since ADRs and GDRs are traded like any other stock, NRIs and foreigners can buy these using their regular equity trading accounts!
Which Indian companies have ADRs and / or GDRs?
Some of the best Indian companies have issued ADRs and / or GDRs. Below is a partial list. Company Bajaj Auto Dr. Reddys HDFC Bank Hindalco ICICI Bank Infosys Technologies ITC L&T MTNL Patni Computers Ranbaxy Laboratories Tata Motors State Bank of India VSNL WIPRO ADR No Yes Yes No Yes Yes No No Yes Yes No Yes No Yes Yes GDR Yes Yes Yes Yes Yes Yes Yes Yes Yes No Yes No Yes Yes Yes
3. FCCB (Foreign Currency Convertible Bonds): FCCBs are quasi-debt instruments issued by a company to the investors of some other country denominated in a currency different from that of domestic country. Principal and interest both are payable in the foreign currency. They carry an option for the investor to convert them into ordinary equity shares of the company at a later stage in accordance with the terms of the issue. In India FCCB are issued in accordance with guidelines and regulations framed under FEMA Act by the RBI and schemes notified by the Ministry of Finance, Government of India. An FCCB issue by a company is governed by FEM (Transfer or Issue of any Foreign Security) Regulations, 2004 (hereinafter ‘Regulations’) and Issue of Foreign Currency Convertible Bonds and Ordinary Shares (through Depository Receipt Mechanism) Scheme, 1993 (hereinafter ‘the Scheme’). The comprehensive guidelines issued on External Commercial Borrowings (ECB) vide A.P. (DIR Series) Circular No. 5 dated August 1, 2005 (hereinafter ‘ECB Guidelines’) are also applicable to FCCB issue. In other words the FCCB are required to be issued in accordance with the Scheme. They will also have to adhere to the Regulations. Further they must be meeting the requirements of the ECB guidelines.
4. External Commercial Borrowings (ECBs): Indian corporate companies are allowed to raise foreign loans for financing infrastructure projects. The last are used as a residual source after exhausting external equity as a main source of finance for large value projects.
International Bond Markets: What is a bond? Bonds are debt. They are debt because when an investor buys a bond they are effectively loaning the bond’s issuer a sum of money and that issuer is incurring a debt. So the issuer – or seller of the bond - is a borrower and the investor - or buyer of the bond - is a lender.
The price paid for the bond is the money the investor is loaning the issuer. And, like most other loans, when you buy a bond the borrower pays you interest for as long as the loan is outstanding and then – at the end of the agreed period of the loan – pays you the loan back.
The Bond Market The bond market (also known as the debt, credit, or fixed income market) is a financial market where participants buy and sell debt securities, usually in the form of bonds. As of 2006, the size of the international bond market is an estimated $45 trillion, of which the size of the outstanding U.S. bond market debt was $25.2 trillion. Average daily trading volume in the U.S. bond market takes place between broker-dealers and large institutions in a decentralized, over-thecounter (OTC) market. However, a small number of bonds, primarily corporate, are listed on exchanges.
Market structure: Bond markets in most countries remain decentralized and lack common exchanges like stock, future and commodity markets. This has occurred, in part, because no two bond issues are exactly alike, and the number of different securities outstanding is far larger. However, the New York Stock Exchange (NYSE) is the largest centralized bond market, representing mostly corporate bonds. The NYSE migrated from the Automated Bond System (ABS) to the NYSE Bonds trading system in April 2007 and expects the number of traded issues to increase from 1000 to 6000. The bonds can be broadly classified as: 1. Foreign bonds: These bonds are issued within a particular country and denominated in the currency of that country, but the issuer is a non-resident. Dollar denominated bonds issued in US domestic markets by non US companies are known as Yankee bonds Yen denominated bonds issued in Japanese domestic markets by non Japanese companies are known as Samurai bonds Pound denominated bonds issued in UK domestic markets by non UK companies are known as Bulldog bonds 2. Eurobonds: These are bonds issued outside the country of the currency in which such bonds are denominated. For instance US dollars denominated bonds issued in Europe, called as “Eurodollar Bonds.” What is the difference between Eurobonds and foreign bonds? Eurobonds are bonds which are underwritten by a multinational syndicate of banks and sold simultaneously in many countries other than the country of the issuing entity. Foreign bonds are bonds which are sold in a particular country by a foreign borrower, and underwritten by a syndicate of members from that country; foreign bonds are denominated in the currency of that country. Evolution of euro currency During 1950s, Russians were earning dollars from the sell of gold and other commodities and wanted to use them to buy grains and other products from the
west, mainly from the US. However, they didn’t want to keep these dollars on deposits with the banks in New York, as they were apprehensive that the US government might freeze the deposits if the cold war intensified. They approached the banks in Britain and France who accepted these dollar deposits. These deposits were in Europe, so ‘euro’ and were dollar deposits so, ‘EuroDollar’ deposits. Later on till 1980s, such deposits were by and large in Europe only. Since 1990, the markets have expanded geographically and also in volume, but the prefix ‘Euro’ has still remained. It strictly and really means ‘offshore’ and not necessarily always referred to Europe. Eurodollar or Eurocurrency refers to bank time deposits in a currency other than that of the country in which the bank or bank branch is located. Euro currency market is the market for such deposits. Euronotes are notes issued outside the country in whose currency they are denominated. Euronotes consist of Euro-commercial paper (ECPs) and EuroMedium-term notes (EMTNs). Commercial papers are unsecured short-term promissory notes issued by finance companies and some industrial companies. EMTNS are medium-term funds guaranteed by financial institutions with the short-term commitment by investors. Global bonds are bonds sold inside as well as outside the country in whose currency they are denominated. For example, dollar-denominated bonds sold in New York and Tokyo are called dollar global bonds. EUROCURRENCY MARKETS: A Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside the country of its origin. Thus US dollars on deposit in London become Eurodollars. The Eurocurrency market consists of those banks – called Euro banks- that accept deposits and make loans in foreign currencies. The Eurocurrency markets enables investors to hold short-term claims on commercial banks, which then act as intermediaries to these deposits into long term claims on final borrowers. The dominant euro currency is US dollars with dollar weakness other currency particularly the Deutcshe mark and Swiss Frank- increased in importance. In Eurodollar markets, banks accept deposits from depositors, mainly corporate depositors. They also place these Eurodollars to other banks. For instance, Citibank may accept deposit from a company Alcoa. Citibank would place this as a deposit to Barclays bank. Barclays to Chase bank. Chase may ultimately lend it to Unilever group, a corporate house. Eurocurrency transactions may be classified as corporate to bank on one hand and bank to another bank on the other hand.
Short term debt instrument 1.Banker’s acceptance BA This instrument is used to finance domestic as well as international trade. On completing the transaction, the exporter hands over the shipping documents and letter of credit LC issued by the importer’s bank to its own bank. At the same time, the exporter draws a draft (or bill) on the importer’s bank and gets paid the discounted value of the draft. A banker’s acceptance (BA) is created when the exporter’s bank presents the draft to the importers bank which accepts it. This BA may be sold (or discounted) as a money market instrument or the exporter may keep it as an asset with himself. Bas are highly standardized negotiable instruments and are available in varying amounts. They permit importers and other users to obtain credit on better terms than simple borrowing. 2. Euro commercial paper Euro commercial paper is a short term Euro note issued by corporates on a discount–to-yield basis. Investor in ECP may be money market funds, insurances companies, pension funds and other corporate bodies having short-term cash surpluses. For investor s, it represents an attractive short-term investment opportunity, unlike a time deposit with financial institution. For borrowers, it is a cheap and flexible source of funds, cheaper than bank loans. As mentioned above, a CP or ECP is a discount redeemed at face value on maturity. For example, an ECP issued at $952.4 with a maturity of 180 days will have a face value of $1,000, if the discount rate is 10 % pa. 3. EURO CERTIFICATE OF DEPOSIT (ECD) A certificate of deposit is an evidence of a deposit with a bank. CD is a negotiable or marketable instrument. Unlike a bank term deposit, a CD can be sold in the secondary market whenever cash is needed. Who ever is holding it at the time of maturity receives its face value in addition to the interest due. Euro CDs are issued by London banks. The interest on floating rate CDs is indexed to LIBOR and Treasury Bill rate, etc. These instruments may be issued in sum like $1, 00,000 or more. For fixed rate CDs, usually there is a single period maturity when principal and interest are paid. 4. REPURCHASE OBLIGATION ( REPO) This is a form of short-term borrowing in which the borrower sells securities to the lender with an agreement to buy them back at a later date. That is why it is called REPO. The repurchase price and selling price are the same. But the original seller has to pay interest while repurchasing the securities. The amount of interest depends on demand–supply conditions. Repos may be overnight repos or of longer maturity.
DOCUMENTATION: The following are the documents generally needed for an euro issue: 1. Prospectus: The prospectus is a major document containing all the relevant information concerning the issues viz investment consideration, terms & conditions, use of proceeds, capitalization details, information about the promoters, directors, industry review, share information etc.. Generally the terms are grouped into financial & non-financial information, issue particulars & others viz statement of accounting showing the significant differences between Indian accounting & US/UK GAAP. The non financial part includes the background of the company, promoters, directors, activity, etc.. The issue particulars talks about the issue size, the domestic ruling price, the number of shares for each GDR etc.. 2. Depository Agreement: This is the agreement between the issuing company & the overseas depository providing a set of rules for withdrawal of depositors & for their conversion into shares. Voting rights are also defined. 3. Underwriting agreement: The underwriters play the role of ‘assurers’ as they undertake to pick up the GDRs at a predetermined price depending on the market response. 4. Subscription Agreement: The Lead manager & the syndicated members form a part of the investors who subscribe to GDRs or bonds as per this agreement. 5. Custodian Agreement: It is an agreement between the depository & the custodian. The depository & the custodian determine the process of conversion of underlying shares into DRs & vice versa. 6. Trust Deed & Paying & Conversion Agreement: While the trust deed is a standard document which provides for duties & responsibilities of trustees, this agreement enables the paying & conversion agency ( performing banking function) undertaking to service the bonds till conversion.
7. Listing Agreement: Most of the companies prefer Luxemburg stock exchange for listing purposes, as the modalities are simplest. The listing agents have the responsibility of fulfilling the listing requirement of a chosen stock exchange. What are some reasons for a company to cross list its shares? A company hopes to: (1) allow foreign investors to buy their shares in their home market; (2) increase the share price by taking advantage of the home country’s rules and regulations; (3) provide another market to support a new issuance in the foreign market; (4) establish a presence in that country in the instance that it wishes to conduct business in that country; (5) increase its visibility to its customers, creditors, suppliers, and host government; and (6) compensate local management and employees in the foreign affiliates.
Types of bond markets: The Securities Industry and Financial Markets Association classifies the broader bond market into five specific bond markets.
• • • • •
Corporate Government & Agency Municipal Mortgage Backed, Asset Backed, and Collateralized debt obligation Funding
Bond market participants Bond market participants are similar to participants in most financial markets and are essentially either buyers (debt issuer) of funds or sellers (institution) of funds and often both. Participants include:
• • • •
Institutional investors; Governments; Traders; and Individuals
Because of the specificity of individual bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions like pension funds, banks and mutual funds. In the United States, approximately 10% of the market is currently held by private individuals.
Bond market volatility: For market participants who own a bond, collect the coupon and hold it to maturity, market volatility is irrelevant; principal and interest are received according to a pre-determined schedule. But participants who buy and sell bonds before maturity are exposed to many risks, most importantly changes in interest rates. When interest rates increase, the value of existing bonds falls, since new issues pay a higher yield. Likewise when interest rates decrease, the value of existing bonds rise since new issues pay a lower yield. This is the fundamental concept of bond market volatility: changes in bond prices are inverse to changes in interest rates. Fluctuating interest rates are part of a country's monetary policy and bond market volatility is a response to expected monetary policy and economic changes.
Bond indices: A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Lehman Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity and/or sector for managing specialized portfolio Issuing bonds
Bonds are issued by public authorities, credit institutions, companies and supranational institutions in the primary markets. The most common process of issuing bonds is through underwriting. In underwriting, one or more securities firms or banks, forming a syndicate, buy an entire issue of bonds from an issuer and re-sell them to investors. Government bonds are typically auctioned.
Features of bonds: The most important features of a bond are: 1. Nominal, principal or face amount: The amount on which the issuer pays interest and which has to be repaid at the end. 2. Issue price The price at which investors buy the bonds when they are first issued, typically $1,000.00. The net proceeds that the issuer receives are calculated as the issue price, less issuance fees, times the nominal amount. 3. Maturity date The date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date.
4. Tenure The length of time until the maturity date is often referred to as the term or tenure or maturity of a bond. The maturity can be any length of time, although debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to thirty years. Some bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in euros for bonds with a maturity of fifty years. In the market for U.S. Treasury securities, there are three groups of bond maturities: short term (bills): maturities up to one year; medium term (notes): maturities between one and ten years; Long term (bonds): maturities greater than ten years.
5. coupon The interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR,(London Inter Bank Offered Rate) or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment. 6. coupon dates The dates on which the issuer pays the coupon to the bond holders. In the U.S., most bonds are semi-annual, which means that they pay a coupon every six months. In Europe, most bonds are annual and pay only one coupon a year. 7. Indentures and Covenants An indenture is a formal debt agreement that establishes the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the U.S., federal and state securities and commercial laws apply to the enforcement of these agreements, which are construed by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bondholders. 8. Optionality: A bond may contain an embedded option; that is, it grants option-like features to the holder or the issuer: 9. Callability: Some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to as callable bonds. Most callable bonds allow the issuer to repay the bond at par. With some bonds, the issuer has to pay a premium, the so called call premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.
10. Puttability Some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; ("Puttable" denotes an embedded put option; "Puttable" denotes that it may be putted.) 11. Call dates and put dates The dates on which callable and Puttable bonds can be redeemed early. There are four main categories. A Bermudan callable has several call dates, usually coinciding with coupon dates. A European callable has only one call date. This is a special case of a Bermudan callable. An American callable can be called at any time until the maturity date. A death put is an optional redemption feature on a debt instrument allowing the beneficiary of the estate of the deceased to put (sell) the bond (back to the issuer) in the event of the beneficiary's death or legal incapacitation. Also known as a "survivor's option". Sinking fund provision of the corporate bond indenture requires a certain portion of the issue to be retired periodically. The entire bond issue can be liquidated by the maturity date. If that is not the case, then the remainder is called balloon maturity. Issuers may either pay to trustees, which in turn call randomly selected bonds in the issue, or, alternatively, purchase bonds in open market, then return them to trustees. Types of bonds: 1. Fixed rate bonds have a coupon that remains constant throughout the life of the bond. 2. Floating rate notes (FRN's) have a coupon that is linked to an Index. Common Indices include: money market indices, such as LIBOR or Euribor, or CPI (the Consumer Price Index). Coupon examples: three month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, typically every one or three months. In theory, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms. 3. High yield bonds are bonds that are rated below investment grade by the credit rating agencies. As these bonds are more risky than investment grade bonds, investors expect to earn a higher yield. These bonds are also called junk bonds.
4. Zero coupon bonds do not pay any interest. They are issued at a substantial discount from par value. The bond holder receives the full principal amount on the redemption date. An example of zero coupon bonds are Series E savings bonds issued by the U.S. government. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently. 5. Inflation linked bonds: in which the principal amount is indexed to inflation. The interest rate is lower than for fixed rate bonds with a comparable maturity. However, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked Gilts in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government. Other indexed bonds, for example equity linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP. 6. Asset-backed securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). 7. Subordinated bonds are those that have a lower priority than other bonds of the issuer in case of liquidation. In case of bankruptcy, there is a hierarchy of creditors. First the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After they have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Therefore, subordinated bonds usually have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. 8. Perpetual bonds are also often called perpetuities. They have no maturity date. The most famous of these are the UK Consol, which are also known as Treasury Annuities or Undated Treasuries. Some of these were issued back in 1888 and still trade today. Some ultra long-term bonds (sometimes a bond can last centuries: West Shore Railroad issued a bond which matures in 2361 (i.e. 24th century)) are sometimes viewed as perpetuities from a financial point of view, with the current value of principal near zero. 9. Bearer bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate can claim the value of the bond. Often they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risky because they can be lost or stolen.
Especially after federal income tax began in the United States, bearer bonds were seen as an opportunity to conceal income or assets. U.S. corporations stopped issuing bearer bonds in the 1960s, the U.S. Treasury stopped in 1982, and state and local tax-exempt bearer bonds were prohibited in 1983. 10. Bear bond, often confused with Bearer bond, is a bond issued in Russian roubles by a Russian entity in the Russian market. 11. Registered bond is a bond whose ownership (and any subsequent purchaser) is recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner. 12. Municipal bond is a bond issued by a state, U.S. Territory, city, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt. 13. Book-entry bond is a bond that does not have a paper certificate. As physically processing paper bonds and interest coupons became more expensive, issuers (and banks that used to collect coupon interest for depositors) have tried to discourage their use. Some book-entry bond issues do not offer the option of a paper certificate, even to investors who prefer them. 14. Lottery bond is a bond issued by a state, usually a European state. Interest is paid like a traditional fixed rate bond, but the issuer will redeem randomly selected individual bonds within the issue according to a schedule. Some of these redemptions will be for a higher value than the face value of the bond. 15. War bond is a bond issued by a country to fund a war. 16. Convertible bond lets a bondholder exchange a bond to a number of shares of the issuer's common stock. 17. Exchangeable bond allows for exchange to shares of a corporation other than the issuer.
Eligibility for issue of Convertible bonds or ordinary shares of issuing company a. An issuing company desirous of raising foreign funds by issuing Foreign Currency Convertible Bonds or ordinary shares for equity issues through Global Depositary Receipt is required to obtain prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India. b. An issuing company seeking permission under sub- paragraph (1) shall have a consistent track record of good performance (financial or otherwise) for a minimum period of three years, on the basis of which an approval for finalising the issue structure would be issued to the company by the Department of Economic Affairs, Ministry of Finance. c. On the completion of finalisation of issue structure in consultation with the Lead Manager to the issue, the issuing company shall obtain the final approval for proceeding ahead with the issue from the Department of Economic Affairs.
Government Bonds In general, fixed-income securities are classified according to the length of time before maturity. These are the three main categories: Bills - debt securities maturing in less than one year. Notes - debt securities maturing in one to 10 years. Bonds - debt securities maturing in more than 10 years.
Corporate Bonds A company can issue bonds just as it can issue stock. Large corporations have a lot of flexibility as to how much debt they can issue: the limit is whatever the market will bear. Generally, a short-term corporate bond is less than five years; intermediate is five to 12 years, and long term is over 12 years. Corporate bonds are characterized by higher yields because there is a higher risk of a company defaulting than a government. The company's credit quality is very important: the higher the quality, the lower the interest rate the investor receives. Other variations on corporate bonds include convertible bonds, which the holder can convert into stock, and callable bonds, which allow the company to redeem an issue prior to maturity.
SYNDICATED LENDING: Syndicated lending is a form of lending in which a group of lenders collectively extend a loan to a single borrower. The group of lenders is called a syndicate. The loan is called a syndicated loan, in contrast to a bilateral loan, which is a loan made by a single lender to a single borrower. Syndicated loans are routinely made to corporations, sovereigns or other government bodies. They are also used in project finance and to fund leveraged buyouts. Syndicated loans are primarily originated by banks, but a variety of institutional investors participate in syndications. These include mutual funds, collateralized loan obligations, insurance companies, finance companies, pension plans, and hedge funds. Syndicate members play different roles. Some just lend money. Others also facilitate the process. It is common to speak of an arranger, lead bank or lead lender that originates the loan, forms the syndicate and processes payments. Most syndicated loans are floaters, paying a spread over Libor, but other structures abound. Fixed-rate term loans, revolving lines of credit and even letters of credit are syndicated. Loans may be structured specifically to appeal to institutional investors. Players in the syndication process: 1. Arranger / lead manager The bank that: Is awarded the mandate by the prospective borrower, and Is responsible for placing the syndicated loan with other banks and ensuring that the syndication is fully subscribed. arrangement fee reputation risk 2. Underwriting bank The bank that Commits to supplying the funds to the borrwoer -if necessary from its own resources if the loan is not fully subscribed. May be the arranging bank or another bank. Not all syndicated loans are fully underwritten. Risk: the loan may not be fully subscribed.
3. Participating bank The bank that participates in the syndication by lending a portion of the total amount required. Interest and participation fee. Risks: Borrower credit risk (as normal loans). A participating bank may be led into passive approval and complacency 4. Facility manager / agent The one that takes care of the administrative arrangements over the term of the loan (e.g. disbursements, repayments, compliance). Acts for the banks. May be the arranging/underwriting bank. In larger syndications co-arranger and co-manager may be used.
Benefits to the borrower Deals with a single bank. Quicker and simpler than other ways of raising capital (e.g. issue of bonds or equity).
Benefits to the lead banks Good arrangement and other fees can be earned without committing capital. Enhancement of bank’s reputation. Enhancement of bank’s relationship with the client.
Benefits to the participating banks Access to lending opportunities with low marketing costs. Opportunities to participate in future syndications. In case the borrower runs into difficulties, participant banks have equal treatment. Participant banks do not find themselves at a disadvantage vis-à-vis a dominant bank or one with high leverage over the client.
Stages in syndication
1. Pre-mandate phase The prospective borrower may liaise with a single bank or it may invite competitive bids from a number of banks. the lead bank needs to: Identify the needs of the borrower. Design an appropriate loan structure. Develop a persuasive credit proposal. Obtain internal approval. Milestone: award of the mandate. 2. Placing the loan The lead bank can start to sell the loan in the marketplace. The lead bank needs to: Prepare an information memorandum Prepare a term sheet Prepare legal documentation Approach selected banks and invite participation Negotiations with the borrower may be needed if prospective participants raise concerns. Milestone: closing of the syndication, including signing.
3. Post-closure phase The agent now handles the day-to-day running of the loan facility.
Pricing fees for “front-end activities” Arrangement and underwriting fees. Interest (margin over base rate). Commitment fees for available but undrawn funds. Agency fees -payable for administrative activity during the term of the loan.
Examples: Aphrodite hills -cyp30m Arranger/agent: HSBC Take over of the shares of Hilton hotel by Louis group -cyp16m -arranger/agent: hsbc. Take over of Rocl shares by Louis -usd30m Agent/arranger: hsbc. acquisition of the vessel emerald by Louis -usd20m Arranger: hsbc Agent: societe general Construction of Elysium beach resort -arranger/agent: Cyprus popular bank. Syndicated loans, like most loans, pose credit risk for the lenders. This can be extreme, as with some leveraged buyouts or loans to some sovereigns. Credit risk is assessed as with any other bank loan. Lenders rely on detailed financial information disclosed by the borrower. As syndicated loans are bank loans, they have higher seniority in insolvency than bonds.
GAAP: "GAAP" is an acronym that stands for Generally Accepted Accounting Principles. GAAP is a framework of accounting standards, rules and procedures, defined by the professional accounting industry, which has been adopted by nearly all publicly traded U.S. companies. GAAP principles, which are updated regularly to reflect the latest accounting methodologies, are the definitive source of accounting guidelines that companies rely on when preparing their financial statements. The standards are established and administered by the American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB). GAAP rules and procedures are what govern corporate accountants when they present the details of a company's financial operations. These details can be found in such places as quarterly balance sheets or income statements, 10-Q filings, or annual reports. Examples of GAAP measures include net earnings, gross income, and net cash provided by operating activities. Why it Matters: Investors should always review a company's GAAP financial results, as the standardized methodology provides a reliable means of comparing financial results from industry to industry and from year to year. However, GAAP rules are sometimes subject to different interpretations, and unscrupulous companies often find a way to bend or manipulate them to their advantage. Furthermore, it is commonplace even for accurate results where GAAP principles were conservatively applied for financial results to be restated at some point in the future. Many companies, for example, often use earnings before interest, taxes, depreciation, and amortization (EBITDA) as a core measure of performance. However, non-GAAP financial measures exclude operating and statistical measures such as employee counts and ratios calculated using numbers calculated in accordance with GAAP. The SEC requires companies to reconcile their non-GAAP financial measures with the closest comparable GAAP measure. Because they can vary widely from firm to firm, non-GAAP calculations do not always provide an apples-to-apples comparison. For this reason, these alternative measures are not meant to replace GAAP, but should instead be used in conjunction with it.
FUTURE PROSPECTS FOR CAPITAL INFLOWS
It has been argued that certain factors- the large size of the Indian market, the intrinsic strength of Indian corporate and India well established and well functioning stock exchanges are conductive to a substantial inflow or foreign equity buy not foreign debt. The success of some Indian companies to float GDRs and euro convertibles during the early 1990s is said to indicate this good potential. There is a need to be circumspect in respect of such sanguine prognostications. The question really is whether the dramatic levels of the total foreign capital will be available to India? It may not be in the country’s interest if say more equity becomes available but the inflow of bank loans and development. Assistance declines. The trends described above should make it clear that the total availability of foreign capital is likely to be strictly limited.
1. Foreign capital is said to fill the domestic saving gap to reduce the foreign exchange barrier and to provide superior physical and managerial technology. 2. The major forms of foreign are bilateral and multilateral (official) concessional assistance and private commercial debt and equity capital. 3. Eurodollars are deposits which are US dollar denominated and held at banks located outside the U.S 4. The bonds floated in the domestic market and domestic currency by a non resident entity is called foreign bonds. 5. GDRs are essentially equity instruments issued abroad b the overseas depository Bank on behalf of the domestic companies against the equity shares of the latter.
Key Terms and Concepts Eurocurrency market consists of banks that accept deposits and make loans in foreign currencies outside the country of issue. Eurodollar could be broadly defined as dollar-denominated deposits in banks all over the world except the United States. Certificate of deposit (CD) is a negotiable instrument issued by a bank. Revolving credit is a confirmed line of credit beyond one year. London interbank offered rate (LIBOR) is British Banker's Association average of interbank offered rates for dollar deposits in the London market based on quotations at 16 major banks. Euro interbank offered rate (EURIBOR) is European Banking Federationsponsored rate among 57 euro-zone banks. Euronote issue facilities (EIF) are notes issued outside the country in whose currency they are denominated. Euronotes are short-term debt instruments underwritten by a group of international banks called a "facility". Euro commercial paper (ECP) are unsecured short-term promissory notes sold by finance companies and certain industrial companies. Euro-medium-term notes (EMTNs) are medium-term funds guaranteed by financial institutions with the short-term commitment by investors. Contagion, as used in this chapter, is where problems at one bank affect other banks in the market. Bank for International Settlements is a bank in Switzerland that facilitates transactions among central banks. Federal funds are reserves traded among US commercial banks for overnight use. Universal bank is one in which the financial corporation not only sells a full scope of financial services but also owns significant equity stakes in institutional investors. Keirutsu is a Japanese word that stands for a financially linked group of companies that play a significant role in the country's economy.
Asian Currency Units (ACUs) is a section within a bank that has authority and separate accountability for Asian currency market operations. International capital market consists of the international bond market and the international equity market. International bonds are those bonds that are initially sold outside the country of the borrower. Foreign bonds are bonds sold in a particular national market by a foreign borrower, underwritten by a syndicate of brokers from that country, and denominated in the currency of that country. Eurobonds are bonds underwritten by an international syndicate of brokers and sold simultaneously in many countries other than the country of the issuing entity. Global bonds are bonds sold inside as well as outside the country in whose currency they are denominated. European Currency Unit (ECU) was a weighted value of a basket of 12 European Community currencies and the cornerstone of the European Monetary System; the euro replaced the ECU as a common currency for the European Union in January 1999. Currency-option bonds are bonds whose holders are allowed to receive their interest income in the currency of their option from among two or three predetermined currencies at a predetermined exchange rate. Currency-cocktail bonds are those bonds denominated in a standard "currency basket" of several different currencies. Amortization method refers to the retirement of a long-term debt by making a set of equal periodic payments. Warrant is an option to buy a stated number of common shares at a stated price during a prescribed period. Zero-coupon bonds provide all of the cash payment (interest and principal) when they mature. Primary market is a market where the sale of new common stock by corporations to initial investors occurs. Secondary market is a market where the previously issued common stock is traded between investors.
Privatization is a situation in which government-owned assets are sold to private individuals or groups.
BIBLOGRAPHY INTERNATIONAL BANKING – K VISWANATHAN FINANCIAL MARKETS AND INSTRUMENTS – L M BHOLE INTERNATIONAL FINANCE – APTE FINANCIAL MARKETS AND SERVICES – GORDAN & NATRAJAN WEBLOGRAPHY: GOOGLE.COM IMF.COM YAHOO.COM ANSWERS.COM
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