New Financial Innovations

y P.C.T.E.)

y A bank certificate issued in more than one country for shares in a foreign company. The shares are held by a foreign branch of an international bank. The shares trade as domestic shares, but are offered for sale globally through the various bank branches. y A financial instrument used by private markets to raise capital denominated in either U.S. dollars or some other freely convertible currency.

For Example
A European investor wanting an exposure in Indian securities could do so via two routes:1. Enter the Indian stock market and buy the cos. Stock on one of the Indian markets. But this would also expose the investor to exchange risks and statutory rules and regulations governing purchase and sale of securities in the Indian market. 2. Through GDRs which would give investors ownership of the Indian company s stock without being subject to Indian stock market regulations to a great extent.

y The exchanges on which the GDR trades are chosen by the company. Currently, the stock exchanges trading GDRs are the: London Stock Exchange, Luxembourg Stock Exchange, Dubai International Financial Exchange (DIFX), Singapore Stock Exchange, Hong Kong Stock Exchange.

GDR as financial instrument
y Depositary Bank y Deposit agreement y Custodian bank

Advantages to an Investor
y It allows investors to invest in foreign country without worrying about foreign trading practices. y Easier trading. y Eliminates custody charges. y Payment of dividend in the GDR currency. y Institutional investors can buy them, even when they may be restricted by law or investment objective from buying shares of foreign companies.

y Eliminates local and transfer taxes. y GDRs are liquid because the supply and demand can be regulated by creating or canceling GDR shares.

Advantages to an Issuing Company
y Access to capital markets outside the home market to provide a mechanism for raising capital or as a vehicle for an acquisition. y Enhancement of company visibility by enhancement of image of the company s products, services or financial instruments in a marketplace outside its home country. y Expanded shareholder base which may increase or stabilize the share price.

y Adjust share price to trading market comparables through ratios. y Enhance shareholders communications and enable employees to invest in the parent company. They have also been used to raise capital in the process of acquisition of other companies by the issuer.

American Depository Receipts

An ADR is a dollar denominated negotiable certificate that represents a non-US company s publicly traded equity. ADRs enable U.S. investors to buy shares in foreign companies without the hazards or inconveniences of cross-border & cross-currency transactions.

Types of American Depository Receipts
y Unsponsored ADR programme. y Sponsored ADR programs
- ADR programme level 1 - ADR programme level 2 - ADR programme level 3

y Rule 144 (A) ADRs.

Unsponsored ADR programme
y What Does Unsponsored ADR Mean?

An American depositary receipt (ADR) that is issued without the involvement of the foreign company whose stock underlies the ADR. Shareholder benefits, voting rights and other attached rights may not be extended to the holders of these particular securities.

y Unsponsored shares are a form of Level I ADRs that trade on the over-the-counter market. y These shares are issued in accordance with market demand, and the foreign company has no formal agreement with a depositary bank. y Unsponsored ADRs are often issued by more than one depositary bank.

Sponsored ADR programme
An ADR which is issued with the cooperation of the company whose stock will underlie the ADR. These shares carry all the rights of the common share, such as voting rights. ADRs must be sponsored to be able to trade on the NYSE.

Level 1 depositary receipts
y Level 1 depositary receipts are the lowest level of sponsored ADRs that

can be issued.

y When a company issues sponsored ADRs, it has one designated

depositary who also acts as its transfer agent.

y A majority of American depositary receipt programs currently trading

are issued through a Level 1 program. This is the most convenient way for a foreign company to have its equity traded in the United States. has minimal reporting requirements with the U.S. Securities and Exchange Commission (SEC). upgrade their program to a Level 2 or Level 3 program for better exposure in the United States markets.

y Level 1 shares can only be traded on the OTC market and the company

y Companies with shares trading under a Level 1 program may decide to

Level 2 depositary receipt
y Level 2 depositary receipt programs are more complicated for a foreign


y When a foreign company wants to set up a Level 2 program, it must file

a registration statement with the US SEC and is under SEC regulation. Level 2 is that the shares can be listed on a U.S. stock exchange. These exchanges include the New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX).

y The advantage that the company has by upgrading their program to

y While listed on these exchanges, the company must meet the

exchange s listing requirements. If it fails to do so, it may be delisted and forced to downgrade its ADR program.

A Level 3 program
y A Level 3 American Depositary Receipt program is the highest level a

foreign company can sponsor.

y The company is required to adhere to stricter rules that are similar to

those followed by U.S. companies.

y Setting up a Level 3 program means that the foreign company is not

only taking steps to permit shares from its home market to be deposited into an ADR program and traded in the U.S.; it is actually issuing shares to raise capital.

y Foreign companies with Level 3 programs will often issue materials

that are more informative and are more accommodating to their U.S. shareholders because they rely on them for capital. Overall, foreign companies with a Level 3 program set up are the easiest on which to find information.

Restricted programs
y Foreign companies that want their stock to be limited to being traded

by only certain individuals may set up a restricted program.

y There are two SEC rules that allow this type of issuance of shares in the

U.S.: Rule 144-A and Regulation S. ADR programs. y 144-A

y Some foreign companies will set up an ADR program under SEC Rule

144(a). This provision makes the issuance of shares a private placement. Shares of companies registered under Rule 144-A are restricted stock and may only be issued to or traded by Qualified Institutional Buyers (QIBs). NYSE ADR programs, and most are held exclusively through the Depository Trust & Clearing Corporation, so there is often very little information on these companies.

y US public shareholders are generally not permitted to invest in these

Regulation S
y The other way to restrict the trading of depositary shares to

US public investors is to issue them under the terms of SEC Regulation S. This regulation means that the shares are not, and will not be registered with any United States securities regulation authority. Person as defined by SEC Regulation S rules. The shares are registered and issued to offshore, non-US residents. after the restriction period has expired, and the foreign issuer elects to do this.

y Regulation S shares cannot be held or traded by any U.S.

y Regulation S ADRs can be merged into a Level 1 program

Meaning of Foreign Exchange Risk
y Foreign exchange risk is the possibility of gain or loss to a firm that occurs due to unanticipated changes in exchange rate .

Types of Foreign Exchange Risk
y Translation Risk y Transaction Risk y Economic Risk

Translation Risk
y It is the degree to which a firm s foreign currency dominated financial statements are affected by exchange rate changes y So, it is only for recording and maintaining he books and not for actual profit or loss figure.

Transaction Risk
It is refers to the extent to which the future value of a firm s domestic cash flow is affected by exchange rate fluctuations. E.g.- In case of import and export, when we deal in foreign currency. If dollar rate is Rs. 46 at the time of contract and Rs. 49 at the time of payment. Then this Rs. 3 per dollar is risk, and directly recorded in balance sheet.

Economic Risk
It is refers to the degree to which firm s present value of future cash flows can be influenced by exchange rate fluctuations.
y Ex. Price of raw material from abroad and local market is 48 and 46 per dollar respectively. If at the time of payment dollar is Rs. 44 then ultimately, we get more benefit on basis of exchange rate gain.

Managing Transaction Exposure
y Forward market hedge y Money market hedge y Here buying and lending takes place and the benefits is sleeked on interest rates.

Managing Economic Exposure
y Market Strategies
y Market selection y Pricing strategies y Promotion strategies y Product strategies

y Production strategies
y Input mix y Shifting production plant y Raise in production

Tools for Transaction Exposure
y Forward or Future hedge for payable y Money Market hedge y Swaps y Option hedge
y Call option y Put option

Forward and Future hedge
y Forward and future hedge allows an MNC to lock in the

specific exchange rate at which it can purchase a specific currency and therefore allows it to hedge the payables denominated in the foreign currency. The contract will include:  currency that the firm will pay 

currency that the firm shall receive amount of the currency rate at which the MNC will exchange the currency future date at which the exchange will take place.

Example of using futures contract with a bank: 

First, let s assume that we sold merchandise to a British firm for 1 million pounds payable in 6 months.  One alternative is to go to our bank who, deals in foreign exchange, and simply lock-in the value of the 1 million pounds sterling that we will receive in six months with a forward contract with the bank.  Assume that the forward rate that the bank offers to us is USD 1.5179 per pound. Then, we are guaranteed that the amount we will receive will be the following: Value of 1 million pound receivable = 1,000,000 pounds * USD 1.5179 per pound = USD 1,517,900  What should be apparent, however, is that whether the pound appreciates or depreciates, we ve locked-in the amount that we will receive: USD 1,517,900.

Money Market Hedge
It involves taking a money market position to cover future payables/recievables positon. Borrowing and lending in multiple currencies, for example to eliminate currency risk by locking in the value of a foreign currency transaction in one's own country's currency. MNCs prefer to hedge payables without using the cash balances. A money market hedge is to take the advantage of higher interest rate prevailing in the other market.

For Example :
A U.S. based importer of Italian bicycles
y In one year owes 100,000 to an Italian supplier. y The spot exchange rate is $1.25 = 1.00 y The one-year interest rate in Italy is

= 4%

Can hedge this payable by buying 96,153.85 = 100,000/ 1.04 today and investing 96,153.85 at 4% in Italy for one year. At maturity, he will have 100,000 = 96,153.85 × (1.04) Dollar cost today = $120,192.31 = 96,153.85 ×$1.25/ 1.00

y To hedge a foreign currency payable, buy a bunch of that

foreign currency today and sit on it. 

Buy the present value of the foreign currency payable today. Invest that amount at the foreign rate. At maturity your investment will have grown enough to cover your foreign currency payable. 

Option Hedge
An option is a contract that gives its owner the right but not the obligation to buy or sell an underlined asset on or before a given date at a fixed price. Types :
y Call Option (buy the currency) y Put Option (sell the currency)

An exchange of streams of payments over time according to specified terms. The most common type is an interest rate swap, in which one party agrees to pay a fixed interest rate in return for receiving a adjustable rate from another party. If companies in different countries have regional advantages on interest rates, a swap will benefit both firms. For example, one firm may have a lower fixed interest rate while another has access to a lower floating interest rate. To take advantage of this situation, the companies would do an interest rate swap.

What Risk Management Products do Firms Use?
y Most firms meet their exchange risk management needs

with forward, swap, and options contracts.

y The greater the degree of international involvement, the

greater the firm s use of foreign exchange risk management.