Milind S Limaye

Broad categories A) Direct Equity / Ordinary shares Preference Shares Debenture / Notes Innovative Debt Instruments

B) Derivatives Forwards Futures Options

Milind S Limaye

Equity / Ordinary shares

It represents ownership capital and its owners i.e. ordinary shareholders / equity shareholders share the reward and risk associated with ownership of corporate enterprises. Authorised equity / share capital Issued capital Subscribed share capital Paid up capital

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Values related to Equity / Ordinary shares Face value Issue price Share premium Book Value Market value

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Features

1) Residual claim to income

the income left after paying expenses, interest charges, taxes, preference dividend, if any. Usually, a part of the residual income is distributed in the form of dividend to the shareholders and other part called retained earnings is reinvested in the business.

2) Residual claim on assets

In case of liquidation of the company, equity shares are the last ones to be paid. They are paid after the claim of preference shareholders have been satisfied. In case of liquidation due to bad financial state of affairs, the equity shareholders generally remains unpaid

Milind S Limaye

3) Right to control Right to control here means the power to take decisions, frame major policies and power to appoint directors. Equity shareholders have the legal power to elect directors on the board and also to replace them if the board fails to protect interest of the shareholders. 4) Voting rights Each equity share carries one vote. Directors are elected in the annual general meeting by the majority votes. Thus, every shareholder can participate in the vital affair of election of directors and cast his vote depending on the number of shares held by him. 5) Limited Liability In a company limited by shares, an equity shareholder's liability is limited to the amount of investment in his respective share. If his shares are fully paid up, he doesn't have to contribute anything in the event of financial stress or winding up of his company.

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Merits 1) Permanent source of funds without repayment obligation 2) It does not involve obligatory dividend payment 3) It forms the basis for further long term financing as it indicates creditworthiness 4) For shareholders with limited liability, they exercise control and share other ownership rights in income / assets of the company

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Demerits From the point of view of company High cost of funds High flotation cost Control on company by majority of shareholders

From the point of view of shareholders

Risky investment No assurance of fixed ROI, No right to claim Dividend No effective and real control Wide fluctuation in share prices
Milind S Limaye

In brief, equity share capital is a high risk high reward, permanent capital market instrument / source of long term finance for corporate enterprises. Shareholders who desire to share risk, return and control associated with ownership of companies would invest in corporate equity. For the corporate, it is a source of long-term fund, with high cost, low risk/ nil risk without any dilution of control and restraint on managerial freedom.

Milind S Limaye

Preference Shares This is a unique type of long term capital market instrument, which combines some of the features of equity shares as well as some of debentures. It has attributes of Equity capital such as dividend is paid out of divisible / NPAT and is non tax deductible, payment of preference dividend depends on discretion of management, irredeemable types of preference shares have no fixed maturity date It has attributes of Debentures such as it has fixed / stated rate of dividend, ranks higher than equity as a claimant to the income /assets, normally does not have voting rights
Milind S Limaye

Features / Attributes Prior claim on Income / Assets Preference shares have a prior claim on the company's income/dividends during its life time and prior claim on the assets of the company in the event of liquidation.

Redemption Redeemable preference shares are those which have a specified maturity date whereas irredeemable preference shares are permanent or perpetual which are payable only in the event of winding up of a company. Fixed Dividend The dividend rate paid to the preference shareholders is fixed and dividends are not tax deductible also. Voting rights Preference shareholders have no voting right but they are granted voting right if the company skips preference dividend for three years.

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Merits To investors Assurance of a stable dividend Preference in dividend payout over dividend paid to equity shareholders

To corporate

No legal obligation to pay preference dividend Redemption can be delayed without significant penalties Forms part of net worth No dilution of control
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Demerits

High cost Modest dividend in the context of associated risk

In brief, preference share / capital involves i) high cost, ii) does not dilute control, iii) has negligible risk, and iv) puts no restraint on managerial freedom
It is however, not a popular capital market instrument in India
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Debentures / Bonds -

Debentures and Bonds represent creditorship securities and Debenture holders / Bondholders are long term creditors of the company These are fixed income (interest) securities.
Features / Attributes 1) Trust Indenture / Deed 2) Interest
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3) Maturity

4) Debenture Redemption Reserve

5) Call and Put provision 6) Security 7) Convertibility 8) Credit rating 9) Claim on income /assets
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Merits For corporate Lower cost due to lower risk and tax deductibility of interest payment No dilution of control as holders do not have voting rights For investors Stable return Fixed maturity Enjoy preferential claim Protected by trust deed
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Demerits Restrictive covenants in Trust Deed Legally enforceable contractual obligation in respect of interest payment and repayments Increased financial risk No voting rights Debenture prices are vulnerable to change in interest rates In short, debentures as long term source of funds / capital market instrument have low cost, do not dilute control, involve high risk and put some restraint on management freedom
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Innovative Debt Instruments / Securities

A) Convertible Debentures / Bonds

It gives the holder right (option) to convert them into equity shares on certain terms. They are entitled to a fixed income till conversion option is exercised and would share the benefits associated with equity shares after the conversion. All the details about the conversion terms i.e. conversion ratio, conversion premium / price and conversion timing are specified in offer document.
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Companies can issue Fully Convertible Debentures (FCDs) or Partly Convertible Debentures (PCDs)

No. of ordinary shares for each CD is conversion ratio

The conversion price is the price paid for ordinary shares at the time of conversion. The conversion time refers to the period from the date of allotment of CDs after which the option to convert can be exercised. If the conversion is to take place between 18 to 36 months, the holder will have the option to to exercise his right in full or part.
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A conversion period exceeding 36 months is not permitted without Put or Call option Compulsory credit rating convertible debentures is necessary for fully

Three types of CDs are presently available in India: i) Compulsorily convertible within 18 months

ii) Optionally convertible within 36 months

Iii) Convertible after 36 months
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Valuation of CCDs The holders of PCDs receive interest at a specified rate, over the term of debentures plus equity shares on part conversion and repayment of uncovered part of the principal. Value of OCDs it depends on three factors i) Straight Debenture Value (SDV), Conversion Value (CV), Optional Value (OV) Merits i) CDs improves the cash flow matching of firms ii) It generate financial synergy
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B) Callable / Puttable Bonds / Debentures / Bond Refunding Beginning from 1992, when IDBI issued bonds with call features, several callable / puttable bonds have emerged in country in the recent years. Call provisions provide flexibility to the company to redeem them permanently. Generally the firm issue bonds at a presumably lower rate of interest when market conditions are favourable to redeem such bonds. In other words, the firm refunds its debt. The bond refunding decision can be analysed as a capital budgeting decision. If the present value of the stream of net cash savings exceeds initial cash outlay, the debt should be refunded Milind S Limaye

C) Warrants A warrant entitles its holders to subscribe to the equity capital of a company during specified period at a specified / particular / certain price. The holder acquire only the right i.e. option but has no obligation to acquire the equity share. Warrants are generally issued in conjunction with / tied to other instruments, e.g. attached to i) secured premium notes and ii) Debentures. It can be issued independently also. Warrants are similar to CDs to the extent that both gives the option / right to buy ordinary shares. While the debentures and conversion option are inseparable, a warrant can be detached. Similarly, the conversion option is tied with the debentures but warrants can be offered independently.
Milind S Limaye

Features of Warrants Exercise price Exercise Ratio Expiry date D) Zero Interest Bonds / Debentures Also known as Zero coupon bonds / debentures, ZIBs do not carry any explicit / coupon rate of interest. They are sold at a discount from their maturity value. The difference between the face value of the bond and the acquisition cost is the gain / return to investors
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Acquisition price = Maturity (face) value / (1+I)n

E) Deep Discount Bonds It is a form of ZIB. It is issued at a deep / steep discount over its face value. The DDB appreciates to its face value over the maturity period. DDBs are being issued by the public institutions in India such as IDBI, SIDBI etc. financial

In 1992 IDBI sold a DDB with face value of Rs.1 lac at a deep discount price of Rs.2,700/- with a maturity period of 25 years.
Milind S Limaye

If the investor could hold the DDB for 25 years, the annualised rate of return would work out to 15.54%. The investor had an option to withdraw (put option) at the end of every five years with a specified maturity / deemed face value ranging between Rs.5,700/- (after 5 years) and Rs.50,000/-(after 20 years). Investors also could sell the DDBs in market. IDBI also had an option to redeem them at the end of every 5 years, presumably to take the advantage of prevailing interest rates.

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F) Secured Premium Notes

SPN is a secured debenture redeemable at a premium over the face value / purchase price. It resembles ZIB.
There is a lock in period for SPN, during which no interest is paid. The holder has the option to sell SPN back to the issuing company, at par, after the lock in period. The redemption is made in installments. It is a tradable instrument. In case of ZIB payment is made in lump sum on maturity, in case of SPN payment is spread over number of years.
Milind S Limaye

G) Floating Rate Bonds (FRBs) The interest on such bonds is not fixed. It is floating and is linked to a benchmark rate such as interest on T Bills, bank Rate, maximum rate of term deposits. It is typically a certain percentage point higher than the benchmark rate. The price of FRBs tend to be fairly stable and close to par value in comparison with fixed interest bonds. They provide investors. protection against inflation risk to

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Forward Contracts
A forward contract is an agreement to buy or sell an asset on a specified date for a specific price. One of the parties to the contract assumes long position and agree to buy the underlying asset on a certain specified future date, for a certain specified price. The other party assumes a short position and agrees to sell the asset on same date for the same price.

Milind S Limaye

Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract. It is normally traded outside stock exchanges. Mostly traded in OTC market.

Salient features:
Since FC are bilateral contracts, it is exposed to counterparty risk Each contract is customer designed and hence is unique in terms of contract size, expiration date and asset type and quality
Milind S Limaye

The contract price is generally not available on public domain On expiry date contract has to be settled by delivery of the asset

If a party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often results in a high price being charged. Forward contracts in forex markets have become very standardised, thereby reducing transaction cost and increasing transaction volume.

Milind S Limaye

FCs are useful in Hedging and Speculation

Hedging for Exporters and Importers

Speculation for the speculators

Limitations of FC Lack of centralisation of trading Liquidity Counterparty risk

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Futures / Future contracts Future markets are designed to solve the problems that exists in forward markets. A future contract is an agreement between two parties to buy or sell an asset at a certain time in future, at a certain price. Unlike to forward contracts, future standardised and stock exchange traded. contracts are

It is a standardised contract with a standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered and a standard time for settlement.
Milind S Limaye

A future contract may be offset prior to maturity by entering into an equal and opposite transaction
Distinction between Futures and Forwards:
Futures Forwards OTC in nature Customised contract terms No margin payment Settlement happens at the end of period

Traded on a organised stock exchange Standardised contract terms Requires margin payment Follows daily settlement

Milind S Limaye

Futures terminology Spot Price The price at which an instrument / asset is traded in the spot market Future price The price at which the future contracts are traded in future market Contract cycle The period over which a contract trades. Index future contracts typically have one month, two months and three months expiry cycles that expires on the last Thursday of the month Expiry date It is the last day on which the contract will be traded, at the end of which it will cease to exist.
Milind S Limaye

Contract size It is the amount of the asset that has to be delivered under one contract. E.g. contract size of NSE future is 200 Nifties Basis It is defined as the future price minus the spot price. There will be a different basis for each delivery month for each contract. In a normal market, basis will be positive. Cost of carry It measures the storage cost plus the interest that is paid to finance the asset, less the income earned on the asset Initial margin It is the amount that is deposited in margin account at the time of futures contract is first entered into.
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Marking to market At the end of each trading day, the margin account is adjusted to reflect the investors gain or loss depending upon the futures closing price. This is called as marking to market. Maintenance margin This is lower than initial margin. It is set to ensure that the balance in margin account never becomes negative. Top needs to be done before next trading day.

Pay off for futures It is the likely profit / loss that would accrue to a market participant with change in the price of underlying asset.
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Pay off for Buyers of futures Long futures

Pay off for Seller of futures Short futures

Pricing Futures The cost to carry Model F=S+C F = S (1+r)T OR

Milind S Limaye

The spot price Jan 1, year 1, of silver is assumed to be Rs.7000/kg. Assuming the annual cost of financing of 15% and no storage cost, the fair value of the future price of 100 gms of silver one month (Jan 30, year1) would be: F=S(1+r)T

Rs.700(1+0.15)*30/365 = Rs.708/If the contract is for a three month period expiring on March 30, year 1, the cost of financing would increase the future price i.e. F= Rs.700 (1.15) * 90/365 = Rs.724.50

Milind S Limaye

Pricing Equity Index Futures The pricing of index futures is also based on the cost of carry model, where the carrying cost is the cost of financing the purchase of the portfolio underlying he index, minus the present value of dividends (amount) obtained from the stocks in index portfolio. If dividend flow throughout the year is generally uniform, pricing under given expected dividend yield can be arrived.

Milind S Limaye

Pricing stock futures

Similar to pricing index futures only with a difference in cost of financing the purchase of stock instead of purchase of the portfolio underlying the index.

Milind S Limaye