innovative international financial products.pptx

7/29/2019 Innovative International Financial Products.pptx

1/46

Innovative International FinancialProducts.

In the last few years, the internationalfinancial system has witnessed theemergence of innovative financialinstruments to cater to a variety ofclients, having different requirements.Let us see some of them in brief:

Floating rates: traditionally bonds havebeen fixed rate instruments. But thebirth of Offshore markets have also

given birth to the concept of floatingrates.

12-Feb-13 1


2/46

Innovative InternationalFinancial Products Since the offshore markets are essentially

short term, the long term instruments arerolled over many times till their maturity, atperiodic intervals when the existing shortterms end giving way to the start of newshortterms.

Since every short term may have a differentinterest rate scenario, the instruments arerolled over to the new term at the thenprevalent rates.

These short terms may be from one day(overnight) to 12 months. But usually therolling over is done at the frequency of 3 or 6months.

12-Feb-13 2


3/46

Innovative International FinancialProducts

The reference rates for the instrumentsare the respective LIBORs quoted to thedepositors and borrowers withappropriate spreads over the LIBORs.

When the bonds are issued with interest

at floating rates (usually reset atquarterly or half yearly intervals), themechanism allows the interest rate riskto be passed from the investor to theissuer of the bonds, and such bonds are

called Floating Rate Notes (FRNs) orVariable Rate Bonds. (Notes are forshort terms and Bonds are for longterms.)

12-Feb-13 3


4/46


In the offshore markets the practice is topay interest on fixed rate bonds annually.

There are also bonds with a combinationof fixed and floating rates in the case of

Drop-lock FRNs, they automaticallyconvert into fixed rates bonds, when shortterm interest rates fall below a certainspecified level.

As of Sep. 2003, as per BIS data, theoutstanding international FRNs andbonds totalled USD 2.23 trillion.

12-Feb-13 4


5/46


Collared floaters: Various modificationsof the FRNs have been introduced toattract investors. For example,collaredfloaters are FRNs with a floorand a cap applicable to the interestpayable.

Inverse Floaters: In this type of security,the applicable rate of interest for aparticular half year is expressed as a

given number say 10% minus theprevailing LIBOR. Therefore for such inverse coupon

floaters, the applicable interest rate riseswhen LIBOR falls and vice versa.

12-Feb-13 5


6/46


These instruments have not proved tobe popular and hence the market forthese bonds is not active.

The instruments can be used with

advantage by investors when theinterest rates are falling and by theissuers when the interest rates arerising.

Perpetual Bonds: Perpetual bondshave no maturity. In the late eighties,some banks issued such bonds in orderto boost their capital adequacy.

12-Feb-13 6


7/46

Innovative InternationalFinancial Products

These bonds are counted as capital of thebanks. For the past several years, therehave been no issues.

Dual Currency Bonds:

The structure of the bond is that the bondis issued in one currency but the issuerretains the option to repay the principal inanother designated currency, theconversion rate being fixed at the time of

the issue itself. Thus the investor also carries theexchange risk for which he iscompensated by a higher couponpayments.

12-Feb-13 7


8/46


In effect it is equivalent to the investorwriting a currency option in favour of theissuer, and the higher coupon acts asthe premium. There are some variationsin these bonds.

If at the time of redemption, theexchange rate is in favour of the issuer,he will not exercise the option of therate fixed earlier but pay at the prevalent

exchange rate.

12-Feb-13 8


9/46


On the other hand, if the prevalentexchange rate is not in his favour, theissuer will exercise the option of payingat the pre agreed exchange rate.

i.e. the issuer repays the redemptionamount in the currency which is theweaker of the two.

An example will clarify:

An Australian $ bond is issued when theexchange rate is 1 A $ = US$ 0.65.

12-Feb-13 9


10/46


A straight bond would have carried acoupon of 7%, but the issuer offers 8%.,and retains the option to repay the bondin US$ at say 1A$=US$ 0.67

At the time of redemption if the A$appreciates over 0.67 US$, then theissuer would exercise the option ofrepaying in US$s at the predeterminedexchange rate of US $ 0.67. On the other

hand if the A$ is trading below US$0.67,the repayment would be made in A$s.

12-Feb-13 10


11/46


Either way, the redemption is done in theweaker of the two currencies, ascompared to the exercise price.

The investor is compensated by the

higher rate of interest The higher coupon rates may or may not

fully reflect the fair price of the option. The unsophisticated investors who do

not understand the intricacies andconsequences of the structure maysuffer.

12-Feb-13 11


12/46


Callable bonds: Some bonds are issued by the issuer with

an embedded call option in their favour,exercisable at the end of stipulated periodbefore maturity.

If the interest rates fall by the time the calloption is available, the issuers will redeemthe bonds by recalling them andrefinancing them by fresh issue of bondsat the prevalent lower rates of interest.

But in these bonds , the couponspayable to the investors is usually morethan the non-callable bonds.

12-Feb-13 12


13/46


Equity lndex-linked notes: These are debt issues carrying a

coupon, but the principal amountrepayable on maturity is linked to an

equity index. If the index is higher as compared to a

base level, the holder will get acorrespondingly larger principalrepayment.

In this structure, some combinations arealso possible:

12-Feb-13 13


14/46


(a) Principal amount unprotected, i.e.could be lower than the face value if, bymaturity, the chosen index is lower thanthe base level;

(b) principal amount protected i.e.could be higher but will not fall belowthe face value and

(c) participative i.e. only a part of theinvestment is linked to the equity index,

instead of the whole amount.

12-Feb-13 14


15/46


Note Issuance Facilities (NIF) andRevolving Underwriting Facility (RUF):

NIF is a medium term commitment on thepart of underwriting banks who areobliged to purchase any short term notesthat the borrower is unable to sell in themarket, at an agreed spread over asuitable benchmark (which can be LIBOR,

or Treasury bill etc.)

12-Feb-13 15


16/46


As soon as the NIF is in place, theborrower may issue the short termpaper at lower spreads (than the ratescommitted by the underwriters) thusreducing the cost of borrowing.

This type of facility can be considered tobe a product in between a bond issueand a syndicated loan facility. Thisproduct is useful for investors who are

not willing to bet on medium or longterm investments.

12-Feb-13 16


17/46


A variation of the NIF is the RUF : Theshort term paper issued by the borroweris for a period of 3 to 6 months whereasthe NIF commitment is a medium termfacility for 5 to 7 years.In the NIF the syndicate undertakes to

buy the unsold notes at the agreedspreads, whereas in the case of RUF,the syndicate lends the amount

equivalent to the amount of the unsoldamounts at the same agreed spread asin the case of NIF.

12-Feb-13 17


18/46


Euro Commercial Paper (EuroCP) CPs are also short term instruments

issued by banks or non bankingcorporate borrowers. There is no

underwriting for CPs but banks maygive a line of credit to the borrowers.The issues are generally high rated andissued in high denominations say US$1

lakh . The instruments attractprofessional investors. Coupon interestmay be paid periodically or may beissued as zero coupons, at discount.

12-Feb-13 18


19/46


Asset Backed Bonds If bonds are issued by a bank or a

corporate on the security of securitizedassets, then they are called Asset

Backed Bonds. Depending on the underlying securities,

the Securitisation can be either MBS(Mortgage Backed Securities) or ABS(Asset Backed Securities assets other

than Mortgages like receivables fromleases, credit cards etc. )

12-Feb-13 19


20/46


Even movie and album receivables,vacation homes are being securitizednowadays).

But the money raised through the

securitisation process would be afraction of the forecasted receipts. These are structured as follows: These

structures involve SPVs (SpecialPurpose Vehicles) to which the future

receipts are assigned and which issuebonds to the investors.

12-Feb-13 20


21/46


Any surplus with the SPV after servingthe structured obligation is passed backto the originator of the transaction.

Securitisation refers to conversion of

cash flows into marketable securities. It is a process through which illiquid

assets are packaged, converted intotradable securities and sold to thirdparty investors.

These assets are generally highly ratedand carry a variety of creditenhancement mechanisms (backed byadditional collaterals).

12-Feb-13 21


22/46


The securities issued are also called asPass Through Certificates (PTCs).

The various entities involved in thisprocess are :

Originator (the seller of the receivables a bank or a non-banking financecompany, a housing finance company ora manufacturing or service company );

SPV, the issuer o the securities (theseare usually small companies with asmall capital or trusts formed for thespecific purpose;

12-Feb-13 22


23/46


the proceeds of the issue are used tobuy the assets from the originator; theinvestors-could be banks, FIs, NBFCs,mutual funds, FIIs or individuals;

Servicer- who collects the periodicinstalments due from individualborrowers in the pool, makes payouts tothe investors and follows up ondelinquent accounts; also furnishes

information to the credit rating agenciesand the trustee on pool performance,charges fee for the services rendered.

12-Feb-13 23


24/46


Trustee Generally reputed banks, FIsor firms of Chartered Accountants orsolicitors.

They have a fiduciary role to oversee the

performance of the transaction untilmaturity with a view to protect theinvestors interests

Rating Agency - Most of the ABSs andMBSs are rated, these agencies play an

important role in the structure. They help the originator in the selection

of pool and structuring of thetransaction.

12-Feb-13 24


25/46


They specify the credit enhancementrequired for the required rating. Alsocontinuously monitor the performanceof the pool and make the necessary

changes in the collateral level. They provide all information to the

merchant bankers and investorsregarding the entire process.

12-Feb-13 25


26/46


American Deposit Receipts (ADRs) ,International Deposit Receipts (IDRs)and Global Deposit Receipts GDRs):

A depositary receipt (DR) is a type of

negotiable (transferable) financialsecurity that is traded on a local stockexchange but represents a security,usually in the form of equity, that isissued by a foreign publicly listed

company. The DR, which is a physical certificate,

allows investors to hold shares in equityof other countries. These are usuallyissued in US $s.

12-Feb-13 26


27/46


The Benefits of Depositary Receipts:The DR functions as a means to increaseglobal trade, which in turn can helpincrease not only volumes on local andforeign markets but also the exchange ofinformation, technology, regulatoryprocedures as well as markettransparency.

Thus, instead of being faced with

impediments to foreign investment, as isoften the case in many emergingmarkets, the DR investor and companycan both benefit from investmentabroad.

12-Feb-13 27


28/46

Innovative InternationalFinancial Products Buying into a DR immediately turns an

investors' portfolio into a global one.Investors gain the benefits ofdiversification while trading in their ownmarket under familiar settlement and

clearance conditions. More importantly, DR investors will be

able to reap the benefits of these usuallyhigher risk, higher return equities, withouthaving to endure the added risks of going

directly into foreign markets, which maypose lack of transparency or instabilityresulting from changing regulatoryprocedures.

12-Feb-13 28


29/46


It is important to remember that aninvestor will still bear some foreign-exchange risk, stemming fromuncertainties in emerging economiesand societies. On the other hand, theinvestor can also benefit fromcompetitive rates the U.S. dollar andeuro have to most foreign currencies.

12-Feb-13 29


30/46


Straight equity issues in theinternational markets are made in theform of Depository Receipts there aregenerally three types:

ADRs: These facilitate public issues andtrading in the United States and aresubject to stringent accounting,regulatory and disclosure requirementsof the US SEC.

The first ADR was introduced byJPMorgan in 1927, for the British retailerSelfridges&Co. The largest depositarybank is the Bank of New York Mellon.

12-Feb-13 30


31/46


IDRs are meant to facilitate issues fortrading in Europe. GDRs are used in the case of issues in

the offshore market combined with

private placement in the USA toprofessional investors. For GDRs, thereare no stringent requirements asapplicable for ADRs.

Since the primary and secondary

markets are mainly in London they arerequired to be listed in London andLuxembourg.

12-Feb-13 31


32/46


The DRs are issued not by the company,but by an international bank acting asthe Depository.

Each DR represents a certain number of

shares of the company, which arephysically held by a custodian appointedby the Depository bank in the country ofthe company, which is the ultimateissuer of the shares.

In the companys books, the DepositoryBanks name appears as the holder ofthe shares.

12-Feb-13 32


33/46


The issue price of the DRs dependsupon the market price of the shares. The company has to bear the

underwriting fees and the commission

which may be upto 3.5 to 4% in additionto the other expenses like in the case ofbond issues.

The company pays the dividends to theDepository bank in the domestic

currency and the Depository distributesthem to the holders of the DRs in $s.

12-Feb-13 33


34/46

12-Feb-13 34

Innovative International Financial

Products Different Levels of ADRs: Level 1 - This is the most basic type of ADR

where foreign companies either don't qualifyor don't wish to have their ADR listed on anexchange.

Level 1 ADRs are traded only on the over-the-counter market and are an easy andinexpensive way to create interest for itssecurities in North America.

Level 1 ADRs also have the minimalreporting requirements from the Securitiesand Exchange Commission (SEC) (Need notfollow US GAAP).


35/46


Products Level 2 - This type of ADR is listed on anexchange (the New York Stock Exchange

(NYSE), NASDAQ, and the AmericanStock Exchange (AMEX).

Level 2 ADRs have slightly morestringent requirements from the SEC,register with SEC and follow US GAAPstandards, but they also get highervisibility trading volume.

12-Feb-13 35


36/46


Products Level 3 - A Level 3 depositary receiptprogram is the highest level a foreign

company can have. Because of thisdistinction, the company is required toadhere to stricter rules that are similar to

those followed by U.S. companies. Setting up a Level 3 program means that

the foreign company is not only takingsome of its shares from its home marketand depositing them to be traded in the

U.S.; it is actually issuing shares to raisecapital In addition, any material information given

to shareholders in the home market, mustbe filed with the SEC through Form 8K.

12-Feb-13 36


37/46


GDRs are also bearer securities andtrading and settlement are done throughCEDEL or Euro Clear.

The DRs are exchangeable into shares at

any time or after the lapse of a specifiedperiod. On conversion into shares theycan be traded in the local stockexchanges.

Earlier due to the problems in settlementand physical delivery of the securities,many of the Indian Companies also haveissued DRs. Now with the vast structuralimprovements, the earlier problems havebeen overcome.

12-Feb-13 37


38/46

12-Feb-13 38

Structure of a GDR Transaction:

Depository

Custodian

LuxembourgListing Agent

LuxembourgStock

exchange

Investors

The Company

LeadManagers

&Syndicate

Euroclear,Cedel

and DTC

IndianLegal

Counsel

Auditors

IndianLegalCounsel

Subscriptionagreement

GDRs

EnglishLegal

Counsel

PR Consul

tants

EnglishLegal

Counsel

Shares


39/46


Collateralised Debt Obligations (CDOs) : In CDOs transactions, the debt security

issued by the SPV is backed by adiversified loan or bond portfolio.

Thus there is a basic difference betweenCDOs and ABSs/MBSs, the latter beinghomogeneous pools of assets such asmortgages or credit card receivables incontrast to the diversified portfolios

backing CDOs.

12-Feb-13 39


40/46


In their simplest version, the credit riskon a portfolio transaction is typicallydivided into at least three tranches, eachcarrying a different level of credit riskand hence coupon.

For example, a US $ 200 mn. Portfoliomay have say US$ 25 mn. as the firstloss tranche, the next US$ 40 mn. as themezzanine tranche and the balance

US$135 mn. as the senior, or safest, partof the debt.

12-Feb-13 40


41/46


If there is any loss, the first losstranche investors will lose first, then themezzanine investors and lastly theseniors.

Mostly the three tranches are sostructured that the most senior debtcarries a AAA rating.

Investment banks often resort to farmore complex structures, which even

sophisticated lenders find it difficult toassess properly, resulting in a series ofdisputes and court cases.

12-Feb-13 41


42/46


Foreign Currency Convertible Bonds(FCCBs): These are quasi equity instruments

since these are considered as debtinstruments for a time frame and arethen converted into equity at the optionof the investor (or at companys option)after the expiry of that particular timeframe.

12-Feb-13 42


43/46


FCCBs have a fixed coupon rate with alegal payment obligation. The price ofthe conversion of FCCB closelyresembles the trading price of the

shares at the stock exchange. TheFCCB may also have a call option.

Euro Convertible bonds have

sometimes options for GDRs for theinvestors.

12-Feb-13 43


44/46

12-Feb-13 44


The Bond Market Association (former name:Public Securities Association) :

International trade association for the bondmarket industry;

Headquarters in London, New York City, andWashington D.C.;

Acted as a global voice for bond issuers andtraders, and co-ordinated with governments,

corporations, and investors. It also had acode of ethics which required members tobehave in a fashion of fairness;


45/46


On November 1, 2006 The Bond MarketAssociation merged with the SecuritiesIndustry Association to form theSecurities Industry and FinancialMarkets Association (SIFMA);

Goals: To promote effective and efficient

regulation;

To facilitate more open, competitive andefficient global capital markets;

12-Feb-13 45


46/46


To champion investor education,retirement preparedness and savings;

To ensure the publics trust in the

securities industry and financialmarkets .

SIFMA links investors and issuers locallyand globally to create economic growth andfinancial security - around the corner, aroundthe world.

innovative international financial products.pptx

Documents