Tarheel Consultancy Services: Corporate Training And Consulting

Tarheel Consultancy Services Corporate Training and Consulting

1 Copyright Tarheel Consultancy Services

Part-01 Financial Systems Institutions, Instruments & Markets

2 Copyright Tarheel Consultancy Services

Barter system & Markets

3 Copyright Tarheel Consultancy Services

The “Markets”  In

a world without markets our time and

energy would be spent in seeking  Those

who have the goods/services that we

want  Those

who are willing to exchange them for

what we have to offer

4 Copyright Tarheel Consultancy Services

Implicit Assumption  Barter 

transaction

Prior to the advent of money, barter was the only means of trade.



Historically, the development of a unit of currency has gone hand in hand with the evolution of markets.

5 Copyright Tarheel Consultancy Services

Countertrade  Barter,

or Countertrade when



The buyer is unable to pay the seller in hard or freely convertible currency.



freely convertible currency : easily accepted as value in other countries

6 Copyright Tarheel Consultancy Services

Example of Barter Telecom switches

AT&T

Sevtelecom

Telecom company

Currency

Telecom company

USA

& Apatite

Russia

seller

buyer

Apatite

Helm AG Trading Firm

Currency

Germany Buyer & Seller

Copyright Tarheel Consultancy Services

7

Money & Markets

8 Copyright Tarheel Consultancy Services

Prior to advent of MONEY

Consume all the goods you have

Exchange your goods for other goods and then consume them

Could not put away goods for later use

9 Copyright Tarheel Consultancy Services

With the advent of MONEY

Everything could be denominated in units of the currency

The currency served as the medium of exchange

Money gave you the freedom to SAVE 10

Copyright Tarheel Consultancy Services

Markets Services

Goods

MARKETS

Physical Assets

Financial Assets 11 Copyright Tarheel Consultancy Services

Categories of Economic Units Economic Units transacting in financial markets

Government Sector

Business Sector

Household Sector 12

Copyright Tarheel Consultancy Services

Income and Expenditure Income = Expenditure

Balanced Budget Units (BBU) Income > Expenditure

Surplus Budget Units (SBU) Income < Expenditure

Deficit Budget Units (DBU) 13 Copyright Tarheel Consultancy Services

Function of a Financial System funds

SBU

DBU claim

e.g.

e.g.

•household sector

•government •business entities

Copyright Tarheel Consultancy Services

•nation as a whole

14

IMPORTS

EXPORTS

BALANCE OF TRADE IMPORTS > EXPORTS = Trade

Deficit

(Net borrower from abroad) IMPORTS < EXPORTS = Trade

Surplus

(Net lender and invest abroad) 15 Copyright Tarheel Consultancy Services

Introduction to Debt & Equity

16 Copyright Tarheel Consultancy Services

Financial Claims funds

SBU

DBU

claim

debt instrument

equity shares

17 Copyright Tarheel Consultancy Services

Debt Claims funds

SBU

DBU debt instrument or IOU •Pay interest at periodic intervals •Repay principal at Copyright Tarheel Consultancy Services maturity

18

Equity Claims funds

SBU

DBU Ownership or equity shares •Claim on profits •Assets remaining after debtors have been paid Copyright Tarheel Consultancy Services

19

Liability

funds

SBU

DBU claim

ASSET

LIABILITY Copyright Tarheel Consultancy Services

20

Balance Sheet

Assets

Liabilities

FUNDS

CLAIMS or DEBT or borrowed capital or EQUITY or owners capital

Total Assets =

Total Liabilities 21

Copyright Tarheel Consultancy Services

Balance Sheet

Assets

Liabilities

Plant & Machinery $ 100 MM

Share Capital $ 100 MM

Bank Deposit

$ 100 MM

Bonds

Total Assets

$ 200 MM

$ 100 MM

Total Liabilities $ 200 MM 22

Copyright Tarheel Consultancy Services

Debt

23 Copyright Tarheel Consultancy Services

Short term debt instruments

Types of debt instruments

Long term debt instruments 24 Copyright Tarheel Consultancy Services

Long term debt securities  Have

a time to maturity of one year or more  Issued by the government or by corporations Bond

Debenture

Firms also issue debt securities for which specific assets are designated as collateral.

In the U.S a debenture is a bond for which no assets of the firm have been specified as collateral.

Secured debt

Unsecured debt

Note: In India the terms bonds and debentures are used interchangeably and thus 25 Copyright Tarheel Consultancy could refer to secured as well as unsecured debt Services

Debt notes issued by the U.S. Dept of Treasury

T-bonds

time to maturity

long term 10 – 30 years

T-notes

T-bills

time to maturity

time to maturity

medium term 1 – 10 years short term 13, 26, 52 weeks

Note: Terminology often differs across countries. e.g. T-notes in Australia, Copyright correspond to T-bills in the U.S Tarheel Consultancy Services

26

Debt (Cont…)  Interest

payments on debt securities are

contractually guaranteed. 

Not a function of the profits made by a firm



A firm is obligated to pay interest on its outstanding debt irrespective of whether or not it has made profits



Interest payments have to be made before any payments can be made to equity shareholders 27 Copyright Tarheel Consultancy Services

Debt (Cont…)  In

the event of bankruptcy, the claims of the bondholders have to be settled first 

If a company defaults on a scheduled interest payment, or principal repayment, the bond holders can stake a claim on its assets.



After liquidating the assets of the firm the claims of the bondholders will be settled.



Only if something were to remain will the equity shareholders be entitled to stake a claim. 28 Copyright Tarheel Consultancy Services

Negotiable vs. Non-negotiable 

Negotiable debt instruments

 Can

be freely traded

Non - Negotiable debt instruments Cannot be traded

Can be endorsed by one Cannot be transferred party to another e.g. Treasury Bond

e.g. bank loans bank time deposits Copyright Tarheel Consultancy Services

29

Break up of the U.S. Market Type of Debt

Amount in billions of USD

Municipal

2,018.60

U.S. Treasury

3,943.60

Mortgage Related

5,472.50

Corporate

4,704.50

Federal Agencies

2,745.10

Money Market

2,872.10

Asset-Backed

1,827.80

TOTAL

23,584.20 30

Copyright Tarheel Consultancy Services

Equity

31 Copyright Tarheel Consultancy Services

 Equity

shares or shares of common stock represent ownership in a business enterprise

shares

dividends part owner

Business enterprise Copyright Tarheel Consultancy Services

32

Dividends  The

rate of dividends is not fixed  It is not contractually guaranteed  Dividends can and do fluctuate from year to year  A company is under no obligation to declare dividends in a particular year  Good companies try to keep dividends at steady levels to avoid sending wrong signals to the outside world 33 Copyright Tarheel Consultancy Services

Retained earnings A

firm will not pay out its entire profits for the year as dividends  A fraction of the profits for the year will be reinvested in the company  If a firm is forced to declare bankruptcy, then the shareholders are entitled to the residual value if any of the business, after the claims of the other creditors are fully settled.

34 Copyright Tarheel Consultancy Services

Equity (Cont…)  Equity

shares never mature, in the sense that they have no expiry date.  

This is because when a firm is created, it comes into existence with the assumption that it will last forever. No one starts a company with the expectation that he will wind it up after a few years.

 Shareholders 

are given voting rights.

That is, they can vote on various issues at the Annual General Meetings of companies, including the election of the board of directors.

35 Copyright Tarheel Consultancy Services

Equity (Cont…)  Not

all shares carry voting rights, however.  There are non-voting shares.  These

shareholders are not entitled to vote  This category is created to restrict corporate control to only certain groups of shareholders.

36 Copyright Tarheel Consultancy Services

Market Statistics Number of companies listed on U.S exchanges

Approx. 15,000

Number of actively traded companies

Approx. 1,000

Total dollar volume of trades on the NYSE in 2000 (in billions )

11,060

Total dollar volume of trades on the Nasdaq in 2000 (in billions )

20,274

37 Copyright Tarheel Consultancy Services

Preferred shares

38 Copyright Tarheel Consultancy Services

Debt

Preferred shares

Equity

Promise a fixed rate of return

If firm is unable to pay as promised then shareholders cannot seek legal recourse

In the event of liquidation, preferred shareholders get priority over equity shareholders

Dividends on preferred shares can be paid only after a company has made interest payments on its outstanding debt until and unless their overdue dividends are paid the firm usually cannot pay dividends to equity holders 39

Copyright Tarheel Consultancy Services

Pre-Tax versus Post-Tax Payments  Equity

and preferred dividends are paid out of

post-tax profits  Interest

paid by the company on debt can be

deducted from the profits while computing its tax liability  This

reduces the tax burden for the firm or in

other words gives it a tax shield 40 Copyright Tarheel Consultancy Services

Example of a Tax Shield  Consider

two companies



Pre-tax profit  $100,000



Company A  0 interest liability



Company B  $20,000 interest expense



Tax rate  30%

41 Copyright Tarheel Consultancy Services

Example (Cont…) Company A

Company B

PBIT

100,000

100,000

Interest

0

20,000

PBT

100,000

80,000

Tax @ 30%

30,000

24,000

PAT

70,000

56,000 42

Copyright Tarheel Consultancy Services

Example (Cont…)  Impact

of the interest expenditure on company B

= Reduction of profits by $14,000 

Effective interest paid = $14,000 (not $20,000)



Effective interest = 14000 =

20000(1-.3) = I(1-T)

43 Copyright Tarheel Consultancy Services

Derivatives

44 Copyright Tarheel Consultancy Services

Derivatives  These

Bonds

are essentially

contracts which are based on, or the

Stocks Derivative contracts

demand for which is

Physical assets

derived from, the demand for an underlying asset.

Foreign currency

Stock market indices 45

Copyright Tarheel Consultancy Services

Classes of derivative securities

Forward contracts

Futures contracts

Options contracts

Swaps

46 Copyright Tarheel Consultancy Services

Forward Contracts  Agreements

for the future delivery of an asset at the end of a pre-specified time period, based on a price that is fixed at the outset

price fixed at outset

pre specified time period

delivery of asset

PRESENT

FUTURE

No money changes hands

Goods are delivered and money is paid 47 Copyright Tarheel Consultancy Services

Example

price fixed at outset

pre specified time period

delivery of asset

PRESENT

FUTURE

1 Nov 2003

15 Dec 2003

Vijay agrees to buy 100 kg of rice from Ajay on 15 Dec 2003 at Rs 14 per kg. No money/assets change hands

48 Copyright Tarheel Consultancy Services

Example (Cont…) 

The contract is negotiated individually between Ajay and Vijay 

Such contracts are called OTC (Over-the-Counter) or customized contracts



No money changes hand on 1 Nov 2003



The actual transaction will take place only on 15 Dec 2003



The terms are set on 1 Nov 2003



Both the parties have an obligation to perform 

Ajay is obligated to deliver the rice on 15 Dec 2003



Vijay is obligated to accept the rice and pay the money on 15 Dec 2003

49 Copyright Tarheel Consultancy Services

Futures Contracts  They

are similar to forward contracts in the sense that they too are agreements for the future delivery of an asset at terms decided upon in advance. 

But forward contracts are customized or Over-TheCounter Contracts (OTC) which are negotiated individually between the buyer and the seller



Futures contracts are traded on organized exchanges like stocks and bonds  These

exchanges are called futures exchanges 50 Copyright Tarheel Consultancy Services

Options Contracts

Call Option

Put Option

•Gives the buyer the right

•Gives the buyer the right

•To buy an underlying asset

•To sell an underlying asset

•On or before a pre specified date

•On or before a pre specified date

•At a pre specified price

Copyright Tarheel Consultancy Services

51

•At a pre specified price

Forward/Futures contract

Options

Futures/forward contracts Call options give the holder impose an obligation to buy the right to buy the underlying the underlying asset, on the asset buyer of the contract

Obligation has to be fulfilled

Rights need be exercised only if such action is beneficial

52 Copyright Tarheel Consultancy Services

Call option

Put option

If the holder of a call option If a put holder were to decides to exercise his right to exercise his right, the seller of buy, the seller of the option the put has an obligation to has an obligation to deliver buy the asset the underlying asset Buyer of both call and put options have to pay a price to acquire the option from the sellers. This is called the Option price or Premium If the right is subsequently exercised, the call/put holder will pay/receive a price per unit of the underlying asset. This is called the Strike or Exercise Price 53 Copyright Tarheel Consultancy Services

Example of a Put Option  Ajay 

buys a put option from Vijay

Gives him the right to sell 100 kg of rice to Vijay at Rs 14 per kg on 15 December 2003



Vijay will not give this right for free



Ajay pays Rs 0.25 per kg or Rs 25 in all to acquire this right



This amount has to be paid at the outset and is called the Option Price or Premium. 54 Copyright Tarheel Consultancy Services

Example of a Put Option 



Assume that the price of rice on 15 December 2003 is Rs.12 per kg 

Ajay will most certainly exercise his option and ask Vijay to pay Rs.1400



This price of Rs.14 per kg is called the Strike Price or Exercise Price



Vijay cannot refuse since he has an obligation to perform

What if the price on 15 December is Rs 16 per kg? 

Ajay will forget the option and sell the rice in the market for Rs 16 per kg



He is in a position to do so since an option is a right and not an obligation 55 Copyright Tarheel Consultancy Services

Example of a Call Option  

Assume that Vijay acquires the right to buy 100 kg of rice from Ajay on 15 December 2003 at an exercise price of Rs.14 per kg Assume that the premium is Rs. 0.40 per kg. 



Assume that the price of the asset on 15 December 2003 is Rs.16 per kg  



Consequently Vijay will pay Rs. 40 to Ajay at the outset

Vijay will happily exercise his option and take delivery at the exercise price of Rs.14 Ajay cannot refuse since he has an obligation

What if the price of rice on 15 December is Rs 12? 

Vijay will simply forget the option and buy from the market at Rs.12

56 Copyright Tarheel Consultancy Services

In summary Instrument

Nature of Buyer’s Commitment

Nature of Seller’s Commitment

Forward/futures contract

Obligation to acquire the underlying asset

Obligation to sell the underlying asset

Call Options

Right to acquire the underlying asset

Contingent obligation to deliver the underlying asset

Put Options

Right to sell the underlying asset

Contingent obligation to take delivery of the underlying asset. 57

Copyright Tarheel Consultancy Services

Swaps  These

are contractual arrangements between

two parties to exchange specified cash flows at pre-specified points in time

58 Copyright Tarheel Consultancy Services

Swaps

Interest rate swaps

Currency swaps

Notional principal

Principal denominated in two different currencies

Copyright Tarheel Consultancy Services

59

Interest Rate Swaps A

principal amount called the Notional Principal will be specified in such cases. 







The principal amount never changes hands and consequently the name Notional Principal. Each party will calculate interest on this notional amount based on a pre-decided method. For instance one party may be obliged to pay interest at a fixed rate of 10% The other may be required to pay at the going interest rate on T-Bonds. 60 Copyright Tarheel Consultancy Services

Interest Rate Swaps  Both

the cash flows will be denominated in the same currency  Hence they can be netted and one party will pay the difference to the other  This is an example of a fixed-rate-variable-rate swap  In practice one can also have a variable-ratevariable-rate swap.

61 Copyright Tarheel Consultancy Services

Cross Currency Swaps  In

this case the principal is denominated in two different currencies. 

Consequently it is exchanged both at inception and at the end of the contract.

 One

party will pay a fixed/variable rate in one currency while the other will pay a fixed/variable rate in the other

62 Copyright Tarheel Consultancy Services

Cont…  At

the end the principal amounts will be swapped back  Since two different currencies are involved, we can have:   

Fixed rate – Variable rate swaps Variable rate – Variable rate swaps Fixed rate – Fixed rate swaps

63 Copyright Tarheel Consultancy Services

Foreign Exchange FOREX markets are used to buy and sell currencies 

A currency is a financial commodity



Each currency will have a price in terms of another currency



The price of one country’s currency in terms of that of another is known as the exchange rate



Currencies are traded amongst a network of buyers and sellers linked by phone/fax.

64 Copyright Tarheel Consultancy Services

FOREX (Cont…) 

Traders do not come face to face on an organized exchange. Major participants are commercial banks and multinational corporations (MNCs).



Physical currency is rarely exchanged.



All transfers are done electronically from one bank account to another.

65 Copyright Tarheel Consultancy Services

Mortgage A

mortgage is a loan backed by real estate as collateral

Periodic payments

Mortgagee

Mortgagor borrower

lender Can take over property Copyright Tarheel Consultancy Services

66

An investor’s concerns Returns

Time pattern

Riskiness

Liquidity

67 Copyright Tarheel Consultancy Services

Returns

•Cash dividends Returns

•Capital gains/losses Time pattern

Riskiness

Liquidity

68 Copyright Tarheel Consultancy Services

Returns (Cont…)  Capital

gains/losses arise when an asset is sold.



If selling price of an asset > The original cost of acquisition  Capital gain



If selling price < Capital loss

 In

the case of bonds, the investor gets returns by way of periodic interest payments known as coupon payments 

There can be capital gains/losses when the bond is sold

69 Copyright Tarheel Consultancy Services

Risk Returns

•May not pay dividends •Capital appreciation may be less/losses

Time pattern

Riskiness

Liquidity

•Firm may go into bankruptcy

70 Copyright Tarheel Consultancy Services

Liquidity  Liquidity

may be defined as follows



`It is the ability of market participants to transact quickly at prices that are close to the true or fair value of the asset.’



`It refers to the ability of buyers and sellers to discover each other quickly and without having to induce a transaction by offering a large premium or discount.’ 71 Copyright Tarheel Consultancy Services

Liquidity (Cont…)  In

liquid markets there will always be plenty of

potential buyers and sellers available. 

So traders will not be required to spend precious time and money in locating counterparties.

 If

a market is liquid  large trades will not have

a significant price impact. 72 Copyright Tarheel Consultancy Services

Liquidity (Cont…)  In

the absence of liquidity, large purchase orders will send prices shooting up, while large sale orders will end up depressing prices substantially.  Liquid markets in other words have a lot of depth.  Securities which trade in illiquid markets are said to be thinly traded.

73 Copyright Tarheel Consultancy Services

Time pattern Returns

Time pattern

Riskiness

Liquidity

•Cash flows from bonds are predictable •Cash flows from dividends can be volatile 74

Copyright Tarheel Consultancy Services

A rational investor Returns

L O W

H I G H

Time pattern

Riskiness

Liquidity

75 Copyright Tarheel Consultancy Services

Types of Rational Investors Young investor

Retired investor

Are more likely to prefer equities. Usually prefer to invest in bonds. May be content with the For them, the key issue is the possibilities of substantial capital availability of predictable periodic gains cash flows from the asset They may not require regular cash flows immediately

The key issue is the availability of predictable periodic cash flows from the asset

More inclined towards risk

Risk averse

Would of course demand Would be content with lower adequate compensation by way returns of higher expected returns Copyright Tarheel Consultancy Services

76

Classification of Markets

Markets

Primary vs. Secondary

Direct vs. Indirect

Money vs. Capital 77

Copyright Tarheel Consultancy Services

Primary vs. Secondary Markets PRIMARY MARKETS

SECONDARY MARKETS

Company offers new financial instruments to the investing public. This very first issue of shares by a company is called an Initial Public Offering or IPO

Once an asset has been bought by an investor from the company, subsequent transactions in the instrument take place in the secondary market

Companies issue shares and bonds

Secondary markets merely represent the transfer of ownership of an asset from one investor to another

Primary markets therefore enable borrowers to raise funds Copyright Tarheel Consultancy Services

78

Primary vs. Secondary Markets PRIMARY MARKETS

SECONDARY MARKETS

TCS is issuing shares for the first time to the public at Rs 850 per share

---

Ravi applies for 1000 shares and Six months later Ravi sells these is allotted 200 shares at a price shares on the National Stock of Rs 850 Exchange for Rs 1250 per share

79 Copyright Tarheel Consultancy Services

Are Primary Markets Alone Sufficient?  In

order to facilitate savings and investment

in the economy we need both primary as well as secondary markets

80 Copyright Tarheel Consultancy Services

Sufficiency? (Cont…)  What 

if we had only primary markets?

If we were to subscribe to a bond we would have no option but to hold it to maturity



In the case of equity shares the problem would be even more serious. We and our heirs would have to hold on to the shares forever.

This will not be a satisfactory arrangement!

81 Copyright Tarheel Consultancy Services

In real life…  We

like assets which can be easily liquidated or converted into cash. 

Liquidity needs can never be perfectly anticipated we need developed and active secondary markets, where assets can be bought and sold easily.

 Nobody    

invests in a single asset

Everyone likes to hold a portfolio of assets. Putting all your eggs in one basket is a very risky proposition. Investors like to spread out or diversify their risk by investing in a pool of securities. Quite obviously, all the companies will not experience difficulties at the same time 82 Copyright Tarheel Consultancy Services

In real life  Our

risk propensity will not remain constant during our lifetimes. 

Young people are more risk taking, while old people are more risk averse.



Consequently investors need the freedom to periodically adjust their portfolios over a period of time.



Once again, secondary markets are critical.

83 Copyright Tarheel Consultancy Services

Direct versus Indirect Markets  In

a direct market, borrowers deal directly with individual and institutional investors who are the ultimate lenders.  For

instance, if IBM were to issue debt and you were to subscribe to it, you would be participating in the direct market.  Borrowers can issue claims in the direct market either through a Public Issue or through a Private Placement. 84 Copyright Tarheel Consultancy Services

Direct & Indirect Markets (Cont…)  In

a Public Issue securities are sold to a large and diverse body of investors, both individual and institutional.  In a Private Placement, the entire issue is placed with a single institution or a group of institutions.  In either case market intermediaries are involved who facilitate a process of `matchmaking’. 85 Copyright Tarheel Consultancy Services

Why do we need intermediaries?  When

an investor seeks to trade, the issue is essentially one of identifying a counterparty. A

potential buyer has to find a seller and vice versa.

 Not

only should a counterparty be available, there should be compatibility in terms of price expectations and quantities sought to be traded. 86 Copyright Tarheel Consultancy Services

Price Compatibility  Every

trader seeks to trade at a `good’

price.  What is a good price?  Buyers

are on the lookout for sellers who are willing to offer securities at a price which is less than or equal to what they are willing to pay.  Sellers seek buyers willing to offer prices greater than or equal to what they expect.

87 Copyright Tarheel Consultancy Services

Quantity Compatibility  The

quantity being offered should match the quantity being demanded.  Often

a large sell order may require more than one buyer to take the opposite position before getting fully executed.  The same is true for large buy orders.

88 Copyright Tarheel Consultancy Services

Market Intermediaries Brokers

Market Intermediary Dealers

Investment Bankers

89 Copyright Tarheel Consultancy Services

Brokers  Brokers

are intermediaries who buy and sell

securities on behalf of their clients 

Arrange trades by helping clients locate suitable counterparties.



They receive a processing fee / commission



They do not finance the transaction

90 Copyright Tarheel Consultancy Services

Dealers 

Dealers maintain an inventory of assets and stand ready to buy and sell at any point in time 

Dealers have funds tied up in the asset



The dealer takes over the trading problem of the client



Dealers specialize in types of markets like T-bill, Commercial paper etc.

91 Copyright Tarheel Consultancy Services

Dealers Client seeking to sell:

Dealer will buy the asset Sell later at higher price

Bid price

Client seeking to buy:

Dealer will sell the asset

Ask / Offer

Replenish inventory later at lower price Copyright Tarheel Consultancy Services

92

Dealers

Sell@Ask - Buy@Bid = Profit = Spread

93 Copyright Tarheel Consultancy Services

Investment Bankers  They

are people who specialize in helping companies bring issues to the primary market. 

They help issuers comply with legal and procedural requirements.  These

include preparing a prospectus or offer document

 Such

a document gives full details about the issue and the potential risk factors for investors to take into account. 94 Copyright Tarheel Consultancy Services

Investment Bankers (Cont…)  They

also provide advice on compliance with

the listing requirements of the stock exchange where the shares are proposed to be listed for trading  They

usually underwrite the issue.

95 Copyright Tarheel Consultancy Services

Underwriting 

What is underwriting? 

An underwriter undertakes to buy that part of the issue which remains unsubscribed if the issue is under subscribed.



Underwriting helps in two ways. 1.

It reduces the risk for the issuer.

2.

It sends a positive signal to potential investors. 1. This is because, in the case of an underwritten issue, a potential investor knows that the banker is willing to take whatever portion of the issue is left unsubcribed

96 Copyright Tarheel Consultancy Services

Underwriting (Cont…)

 An

investment banker may not however like to

take on the entire risk.  Sometimes

a group of investment bankers may

underwrite an issue.  This

is called Syndicated Underwriting.

97 Copyright Tarheel Consultancy Services

Best Efforts  At

times, an investment bank, instead of underwriting the issue may offer to sell it on a best efforts basis. 

It will try and do everything to ensure that the issue is fully subscribed to



It does not undertake to pick up the unsubscribed portion in the event of undersubscription. 

Thus the role of the investment bank in these cases is purely a marketing function. 98 Copyright Tarheel Consultancy Services

Underwritten Issue or Best Efforts?  Most 

issues are underwritten in practice.

Issuers prefer this, because there is a greater incentive for the banker to sell when there is a risk of devolvement.

99 Copyright Tarheel Consultancy Services

Devolvement  What 

is Devolvement Risk?

It is the risk that the bank has to buy the unsold securities in the event of undersubscription



Devolvement is a clear signal of negative market sentiments.



It will lead to a loss for the investment banker because the acquired shares will inevitably have to be disposed off at a lower price. 100 Copyright Tarheel Consultancy Services

Underwriting (Cont…)  The

fee for underwriters in the U.S. is about 7% of the issue amount.  Sometimes the bank may also be offered an option to buy additional shares at the original issue price. 

These options can become very valuable if the issue succeeds, for the stock price will then rise perceptibly.

 Companies

who seek to retain an option to issue additional shares in the event of oversubscription are said to have a Greenshoe option. 101 Copyright Tarheel Consultancy Services

Underwriting (Cont…)  E.g.

The CIT Group came out with an IPO in 2000 

Offered 200 million shares



Plus a greenshoe option for 20 million shares that could be purchased by the members of the underwriting syndicate at the offer price of $ 23 within 30 days from the date of the issue.



The greenshoe option is also called the overallotment option. 102 Copyright Tarheel Consultancy Services

Underwriting (Cont…)  The

underwriting fee compensates the investment bank for the sales effort as well as for the insurance service provided to the issuing company. 

Since a best efforts offer does not involve the insurance component, the corresponding fees and commissions tend to be lower.

 Underwriting

fees are negotiated between the investment bank and the client. 

The fee is a function of the risks involved, and the amount of capital required to be deployed. 103 Copyright Tarheel Consultancy Services

The Glass-Steagall Act  This

act, known more formally as the Banking Act of 1933 segregated investment banking activities and commercial banking activities. 



During the Great Depression of 1929-1933 many commercial banks went bankrupt when the stock markets collapsed because they had significant exposure in the market. Once the Act was enacted following the depression, bankers were given a clear choice between deposit taking and lending on one hand, and underwriting and securities dealing on the other. 104 Copyright Tarheel Consultancy Services

Glass-Steagall (Cont…)  The

Act thereby segregated Investment Banking & Brokerage Operations from Commercial Banking.  In 1971 the Supreme Court passed a ruling allowing commercial banks to set up holding companies, which could then set up a separate subsidiary for brokerage operations. 

Brokerage companies set up by such holding companies came to be known as section 20 brokerage firms. 105 Copyright Tarheel Consultancy Services

Glass-Steagall (Cont…)  The

Glass-Steagall Act was repealed in 1999,

with the passage of the Financial Services Modernization Act. 

This Act is referred to as the Gramm-Leach-Bliley Act.

106 Copyright Tarheel Consultancy Services

Top Underwriters of U.S. Debt and Equity as of 1996 FIRM

Amount in Billions

Market Share

Merrill Lynch

155.90

16.40%

Lehman Brothers

100.70

10.60%

Goldman Sachs

98.50

10.30%

Salomon Brothers

96.20

10.10%

Morgan Stanley

83.70

8.8%

J.P. Morgan

68.70

7.20%

CS First Boston

60.00

6.30%

Bear Stearns

41.70

4.40%

Donaldson, Lufkin

34.80

3.60%

Smith Barney

29.90

3.10%

Top 10 Firms

770.10

80.80% 107

Industry Total

953.40

Copyright Tarheel Consultancy Services

100.00%

Indirect Markets LENDERS

BORROWE R

LENDER individual

Corporate borrower family

Commercial bank

Financial claims

Copyright Tarheel Consultancy Services

Non – corporate borrowers

Financial claims

108

Indirect Markets - Risks  Individual

/ family depositors are exposed to the

risk of failure of the bank  The

banks are exposed to the risk that

corporate borrowers could fail

109 Copyright Tarheel Consultancy Services

In. Market Intermediaries Insurance cos

I. Market Intermediary Mutual funds

Pension funds

110 Copyright Tarheel Consultancy Services

Indirect Markets (Cont…)  The

depositors have no claim on the ultimate

borrowers in this case.

 How  By

does the bank make money? raising deposits at a rate that is lower than the

interest rate charged by it on loans made to borrowers. 111 Copyright Tarheel Consultancy Services

Benefits of Direct Markets  When

a borrower and a lender interact directly,

they can share the profit 

Profit will otherwise be made by the intermediary

112 Copyright Tarheel Consultancy Services

Indirect Markets

BORROWE R

LENDERS LENDER individual

Corporate borrower family

Commonwealth Bank 4% pa

5% pa Telstra etc.

Financial claims Copyright Tarheel Consultancy Services

Financial claims

113

Illustration (Cont…)  Assume

that Telstra can directly issue bonds to

the public, with a coupon rate of 4.75%.  Investors

 get 0.75% extra as compared to bank

deposit  Telstra

 Will save 0.75% as compared to borrowing

from the bank  Bank’s

margin of 1.5% has been shared by the

company & investors 114 Copyright Tarheel Consultancy Services

Disadvantages of Direct Markets  One

problem is that the claims issued by the borrowers may not match the requirements of the individual lenders 

The problem: Denomination and/or Maturity.



Borrowers like to borrow long term whereas lenders like to lend short term.  E.g.

A co. issuing 20 year bonds  may not find many takers if it directly approaches the public

 E.g.

A firm issues bonds with a face value of $100,000  small investors will be unable to subscribe.

115 Copyright Tarheel Consultancy Services

Disadvantages (Cont…)  These

problems do not exist for financial institutions 

 



They have access to funds deposited by many investors  large denominations pose no problems for them Deposits keep getting rolled over These intermediaries can afford to  borrow short term & lend long term These intermediaries are said to engage in denomination transformation as well as maturity transformation

116 Copyright Tarheel Consultancy Services

Disadvantages (Cont…) 

Another problem with direct markets is that they are critically dependent on active secondary markets



The cost of a public issue can be very high  Prospectus  Share  Legal  Fees

printing costs

application printing costs fees

paid to advisors

117 Copyright Tarheel Consultancy Services

Role of Intermediaries in Indirect Mkts  Banks,

mutual funds etc. have access to large pools of money. 



They also accept deposits ranging from a few dollars to a few million dollars. They can therefore easily subscribe to large denomination assets

 They

can also accept short term deposits and lend long term. 

Deposits keep getting rolled over, either due to renewals, or due to new clients. 118 Copyright Tarheel Consultancy Services

The Role of Intermediaries (Cont…)  Financial

institutions also facilitate risk diversification. 







Diversification means that `don’t put all your eggs in one basket’ It is costly for an individual investor to diversify across assets because of transactions costs.  In practice, each time a security is bought or sold, the trader incurs transactions costs. Banks indirectly diversify because every deposit is invested across a spectrum of projects. Banks can afford to employ professionals who can assess risk related issues.

119

Copyright Tarheel Consultancy Services

The Role of Intermediaries (Cont…)  Finally

financial institutions are able to take

advantage of economies of scale 

The fixed costs of their operations tend to get spread over a vast pool of transactions and assets



This leads to cost efficiency as compared to an individual borrower/lender

120 Copyright Tarheel Consultancy Services

Money Mkts. vs. Capital Mkts. Money Markets

Capital Markets

Time

to maturity at the time of issue Markets for medium to long term is one year or less instruments Money

Capital market securities include market instruments by definition have to be debt instruments both long and medium term debt as well as equities Money

markets are used to adjust Capital markets channelize funds temporary liquidity imbalances. In from those who wish to save to those practice, for any company, inflows who seek to make long term and outflows at any point in time will productive investments rarely match Money

markets help firms to borrow Capital markets are where short term and also to deploy surplus companies source funds for their long funds on a short term basis term investment needs 121

Copyright Tarheel Consultancy Services

Money & Capital Markets  Money

markets tend to be wholesale markets.



These instruments have high denomination.



Hence small investors usually do not participate in such markets



Small investors can participate indirectly by investing in Money Market Mutual Funds (MMMFs).



These funds primarily invest in money market securities

122 Copyright Tarheel Consultancy Services

Money & Capital Markets (Cont…)  These 

securities carry relatively low default risk.

The odds of a firm getting into financial difficulties in the short run are definitely less than such an event occurring over a longer term horizon

 Money 

markets tend to be very liquid

The trading volumes are very high

123 Copyright Tarheel Consultancy Services

Secondary Markets  Financial

assets are usually traded on

exchanges  What

is an exchange?



It is a trading system where traders interact to buy and sell securities



A trader, to trade, has to be a member of the exchange



Non members have to route their orders through a member 124 Copyright Tarheel Consultancy Services

Example - Secondary Markets  If

you want to trade on the NSE, you have to

approach a registered broker or a sub-broker  He

will then feed your order into the electronic

system

125 Copyright Tarheel Consultancy Services

Historically

Today

Open-Outcry: Historically trading These days most exchanges are on exchanges has taken place on electronic communications trading rings / floors networks and most traders no The BSE used to have this longer interact face to face system until it introduced online trading Many older exchanges (e.g. NYSE) have a combination of floor based and electronic trading Traditionally exchanges have been owned by the member brokers and dealers

Of late many exchanges are characterized by corporate ownership. Such exchanges are said to be demutualized The NSE is owned by a number of institutions such as IDBI, LIC etc. 126

Copyright Tarheel Consultancy Services

Examples of Demutualized Exchanges  The

NASDAQ

 The

Stockholm Stock Exchange

 The

Toronto Stock Exchange

 The

Deutsche Borse

 The

National Stock Exchange

 The

Chicago Mercantile Exchange 127 Copyright Tarheel Consultancy Services

Stock Exchanges  These

are markets where shares of common stocks of companies are traded  When a corporation desires that its shares be admitted for trading, it has to first apply to have its shares listed 



In the U.S. about 8,250 stocks are listed on the major exchanges. Only a small fraction of these are actively traded On the NYSE the 250 most active stocks accounted for 62% of the reported trading volume, and an even larger percentage of the dollar volume in 2000 128 Copyright Tarheel Consultancy Services

Listing vs. Registration  What 



It is a process by which a company applies and gets permission for its securities to be traded on a stock exchange. The exchange will insist on certain minimum standards before granting approval. These pertain to issues like capital value, number of shareholders, and financial soundness.

 What 

is Listing?

is Registration?

This is a process required under the Securities and Exchange Act for most publicly held corporations. 129 Copyright Tarheel Consultancy Services

Listing and Registration Listing

Registration

There is no legal requirement Registration is mandatory and that a company should get its requires the submission of shares listed on an exchange periodic financial reports and reports of major corporate events to the SEC Most exchanges require that All listed securities must be the companies regularly registered with the SEC report their accounts in accordance with Generally Accepted Accounting Practices (GAAP) Copyright Tarheel Consultancy Services

130

Listing 

Benefits of listing: 1.

Trading of listed shares is easier and the company will attract a broader class of shareholders



2.

Listing gives the company enhanced visibility

3.

It becomes easier for the company to raise capital

Once approval is granted a company has to pay the prescribed listing fees 131 Copyright Tarheel Consultancy Services

Listing Fees on the NYSE (as of 2002) 

Original listings (one time fee per company): $ 36,800



Initial Fees (rates per million shares) 

1st and 2nd Million - $ 14,750



3rd and 4th Million - $ 7,400



5th and up to 300 million - $ 3,500



In excess of 300 million - $ 1,900



Minimum original listing fee (including special charge): $ 150,000



Maximum original listing fee (including special charge): $ 250,000 132 Copyright Tarheel Consultancy Services

Multiple Listings  Most

companies list their stocks on more than

one exchange 

The main exchange where the stock is originally listed is called the Primary Listing Market.



E.g.:  NYSE  AMEX  NASDAQ 133 Copyright Tarheel Consultancy Services

Multiple Listings (cont…)  Most

listed stocks in the U.S also trade on one

or more regional exchanges. 

E.g.:  The

Boston Stock Exchange

 The

Chicago Stock Exchange

 The

Cincinnati Stock Exchange

 The

Philadelphia Stock Exchange

134 Copyright Tarheel Consultancy Services

The Third Market A

collection of dealers and brokers who arrange trades in exchange listed stocks, away from the exchange History

Today

Began to develop when institutional investors became dissatisfied with the liquidity and commissions for large trades on the exchanges

These quotes are displayed on the Nasdaq Intermarket

Used by traders to trade large blocks without alerting the market 135 Copyright Tarheel Consultancy Services

The Fourth Market  These

are electronic trading systems also known as Alternative Trading Systems (ATS). Usually sponsored by registered broker-dealers

Computerized trading networks that match buy and sell orders entered electronically Orders that cannot be immediately matched are posted for viewing by investors who may wish to take an 136 offsetting position Copyright Tarheel Consultancy Services

The Fourth Market (cont…)  E.g.:  Island

ECN  Instinet  REDIBook  Archipelago  Bloomberg Tradebook

137 Copyright Tarheel Consultancy Services

International Stock Exchanges  Over

the past two decades exchanges have

mushroomed across the globe 

Happened due to the increasing acceptance of free market economic mechanism which has manifested itself by the LPG process - Liberalization, Privatization, and Globalization.

 Not

all emerging market exchanges have been

success stories

138 Copyright Tarheel Consultancy Services

International Exchanges 

Successful exchange development requires

Strong property rights

Successful privatization programs

Strong contract laws and securities regulation laws

Regulatory authorities with teeth



Deutsche Borse



Italy



Korea



Euronext



Stockholm



Osaka



London



Switzerland



Taiwan

Madrid



Australian





Hong Kong

Tokyo



Copyright Tarheel Consultancy Services

139

Bond Markets  The

number of different corporate and municipal

bond issues far exceeds the number of available stocks 

 In

Bond markets are not very liquid.

practice many bonds never trade after issue,

because investors who buy them, choose to hold them till maturity. 140 Copyright Tarheel Consultancy Services

Bond Markets (cont…)  The

number of government bond issues is less, but the issue sizes are much larger 

These bonds are more actively traded

 Most

corporate and municipal bonds trade OTC in investment and commercial banks

 Some

stock exchanges list corporate bonds, but trading volumes are much higher in OTC markets 

E.g. Less than 0.10% of all corporate bond trading volume occurs on the NYSE and the AMEX bond markets 141 Copyright Tarheel Consultancy Services

Bond Markets (cont…)  Secondary

trading of T-Bonds is also primarily

on OTC markets.  Many

brokers however organize markets in

which large government bond dealers and traders trade with each other 

These inter dealer brokers facilitate anonymous trading.



E.g. the largest of them is Cantor Fitzgerald.

142 Copyright Tarheel Consultancy Services

Derivatives Markets  There

are 5 exchanges in the U.S that trade

options contracts on equity shares and stock market indices 

Buyers can buy contracts on a particular exchange and sell them on another exchange, thereby neutralizing or offsetting their positions



Investment banks trade options contracts OTC

143 Copyright Tarheel Consultancy Services

Derivatives Markets (Cont…)  Outside

the U.S most stock options contracts trade on the same stock exchange where the underlying stocks are traded 

E.g. Both underlying stocks as well as stock options trade on the NSE

 The

SEC has not permitted equity shares and options written on them to trade side by side.

 Even

when they trade on the same exchange, they do so in different rooms. Copyright Tarheel Consultancy Services

144

Derivatives Markets (Cont…)  Futures  In

contracts trade on futures exchanges.

the U.S. stock index options also trade on

futures exchanges.  In

most other countries, stock index options

trade on stock exchanges. 145 Copyright Tarheel Consultancy Services

Actors or Players  Traders

in the market can be divided into two categories.

Those who trade on their own Those that arrange trades for account others Proprietary traders trade on their own account

Agency traders act on behalf of or as agents of others who wish to trade They are also known as brokers, commission traders, or commission merchants (in futures markets). 146

Copyright Tarheel Consultancy Services

Long Positions A

trader who owns an asset is said to have a

Long position 

People with long positions have the ability to sell on a future date



They gain if prices rise and lose if prices fall



Those wanting to take long positions attempt to buy low and sell high 147 Copyright Tarheel Consultancy Services

Short Positions A

trader is said to have a Short position in the stock market when he has sold an asset that was not owned by him

 How

can you sell something that you do not own? 

Borrow it from someone else and sell it



Thus the trader has to eventually buy the asset and return it to the investor who lent it to him



Hopefully prices would have declined by then 148 Copyright Tarheel Consultancy Services

Short Positions (cont…)  When

a person with a short position re-acquires

the asset, he is said to be `covering his position’  The

objective of a short seller is:

sell

high and buy low

149 Copyright Tarheel Consultancy Services

Buy Side & Sell Side  The

trading industry can be classified into a buy side and a sell side 



The most important of these services is liquidity The terms buy side and sell side have nothing to do with the actual buying and selling of securities

Buy side

Sell side

traders who traders who seek to buy the offer the services offered services of the by the exchange exchange traders are traders are those in search those who of liquidity supply liquidity traders on both sides regularly buy as well as sell securities

Copyright Tarheel Consultancy Services

150

Buy side

Sell side

Refers to the portion of the securities business in which primarily institutional orders originate

Consists of brokers and dealers who help buy side traders to trade at their convenience This

Funds

(mutual and pension)

Firms Governments Insurance

Companies Charitable and Legal Trusts

is selling liquidity

Market

makers Specialists Floor Traders Locals Day Traders Scalpers

Copyright Tarheel Consultancy Services

151

Examples - The Sell Side  Brokers

are of various types.



Retail brokers – Charles Schwab



Discount brokers – E*Trade



Full service brokers – Dreyfus



Institutional brokers – Abel/Noser Corporation



Futures Commission Merchants – Cargill Financial Markets Group 152 Copyright Tarheel Consultancy Services

Examples - The Sell Side  Broker

dealers in the U.S. include well known

investment banks like: 

Goldman Sachs



Salomon Smith Barney



Morgan Stanley Dean Witter



Credit Suisse First Boston

153 Copyright Tarheel Consultancy Services

Definitions  Who 

is a market maker?

A person/firm who on a continuous basis buys and sells securities on his own account



Market makers usually try and profit from a rapid turnover in securities positions



They do not hold open positions for long in anticipation of gradual price movements 154 Copyright Tarheel Consultancy Services

Definitions  Who

is a specialist?



An exchange member who is a market maker in one or more securities



The person on the exchange floor who the other members approach when they wish to transact or leave an order



A specialist is assigned securities by the exchange and is expected to maintain a fair and orderly market



A specialist is also known as an Assigned Dealer 155 Copyright Tarheel Consultancy Services

Clearing  What

is clearing?

When a trade occurs: (either on the exchange floor, or over the telephone): •Both parties will make a record of the terms of the trade & the identity of the counterparty Before the trade is settled: •The two records must be compared to ensure that the facts and figures tally. This is called clearing Copyright Tarheel Consultancy Services

156

Clearing Agents  Clearing

agents are entities which match and verify

records, in order to confirm that both the parties have agreed on the same terms and conditions. 

E.g. The largest clearing agency in the U.S is the National Securities Clearing Corporation (NSCC)

157 Copyright Tarheel Consultancy Services

Clearing Agents (cont…) If the records match: •The trade is said to clear •It can then be settled If there is a discrepancy: It will be reported to the traders The traders will then try and resolve the problem Trades with discrepancies are called DKs (Don’t Knows) In the futures markets they are called Out Trades Copyright Tarheel Consultancy Services

158

Clearing Agents (cont…) History

Today

Orders are manually matched In electronic systems, the orders are matched by the computer, which contains all the required information about the orders Clearing is a very important exercise in the context of conventional manual exchanges

Consequently clearing becomes a trivial exercise

159 Copyright Tarheel Consultancy Services

Settlement Agents  What

do we mean by settling?



Payment of cash by the purchaser & the delivery of securities by the seller



The job of a settlement agent is:  receive

the cash from one party

 receive

the securities from the other party

 ensure

that the amounts are in order

 pass



the cash/securities to the counterparty

E.g. The largest settlement agent in the U.S is the NSCC, which is not surprising since clearing and settlement are related functions Copyright Tarheel Consultancy Services

160

Settlement (Cont…)  Normal-way

settlement in the U.S occurs 3

business days after the day of trade. 

This is called T+3 settlement.



There are also special settlements like cash settlements.  Cash

settlement means that the trade is cleared and

settled on the day of trade itself. 161 Copyright Tarheel Consultancy Services

Depositories  What

is a Depository?



It is a centralized location in which security certificates are placed and stored for later transfer



Such transfers usually take place by book entry rather than by physical movement

 E.g.

The largest depository in the world is the Depository Trust Company (DTC), which holds nearly 20 trillion dollars in assets 162 Copyright Tarheel Consultancy Services

Custodians  Who 

is a custodian?

It is an organization, typically a commercial bank, that holds in custody and safekeeping assets belonging to its customers.



For a fee, the institution will collect dividends, interest, and proceeds from security sales and will disburse funds according to the clients’ instructions. 163 Copyright Tarheel Consultancy Services

Depositories & Custodians  They

facilitate the settlement process by quickly

transferring cash and securities to settlement agents upon receiving instructions from the traders.

164 Copyright Tarheel Consultancy Services

Arbitrage  What 

is arbitrage?

Arbitrage may be described as the existence of the potential to make riskless profits by transacting in multiple markets.

165 Copyright Tarheel Consultancy Services

IBM shares NYSE

LSE

$180 per share

£100 per share Exchange rate 2 $/ £

Borrow $18,000. Buy 100 shares on NYSE

Sell on LSE for £10,000 $20,000

Transfer back to NY

Profit = $2000 This transaction is Tarheel costless and risk-less in a perfect Copyright Consultancy Services

166

These opportunities cannot persist for long NYSE $180 per share

IBM shares

LSE £100 per share

Exchange rate 2 $/ £

Buy on NYSE Price rises

Sell on LSE Price falls

Exchange rate will come down from 2 $/ £

Equilibrium isServices restored Copyright Tarheel Consultancy

167

Arbitrage & Market Imperfections  In

practice investors have to incur transactions

costs. 

Brokerage fees have to be paid when shares are bought and sold.



Commissions have to be paid while buying and selling foreign exchange.

 Such

costs will certainly reduce and may even

eliminate profit opportunities for small investors. 168 Copyright Tarheel Consultancy Services

Imperfections (cont…)  Institutional

investors however face much lower transactions costs. 



Since they can arrange their own trades, they need not pay brokerage fees while trading. More importantly they have substantial capital at their disposal which can be deployed for such activities.

 Thus

the kind of arbitrage described is often feasible for such investors, who will consequently exploit such situations till they cease to exist. 169 Copyright Tarheel Consultancy Services

IBM shares NYSE

LSE

$180.75 / $181.25

£100.25 / £100.5

Exchange rate 2.05/2.15 $/ £

Borrow $18,125 Buy 100 shares on NYSE

Sell on LSE for £10,025

$20,551.25

Transfer back to NY

Profit = $2426.25 Copyright Tarheel Consultancy Services

170

Illustration (Cont…)  Assume

that a commission of 10c per share is

payable in New York  Let

the commission in London be 5p per share

 Assume

that the dealer charges a flat

transactions fee of £25 while selling dollars.  What

will be the consequences?

171 Copyright Tarheel Consultancy Services

IBM shares NYSE

LSE

$180.75 / $181.25

£100.25 / £100.5

Exchange rate 2.05/2.15 $/ £

Borrow $18,135 Buy 100 shares on NYSE

Sell on LSE for £10,020

9995 x 2.05 = $20,489.75

Transfer back to NY

Profit = $2354.75 Copyright Tarheel Consultancy Services

172

The Eurocurrency Market  What 



is a Eurocurrency?

A freely traded currency deposited in a bank outside its country of origin. The term Euro simply means outside the country of origin  E.g.: • Dollars traded outside the U.S. are Eurodollars. • Yen traded outside Japan are Euroyen. • Euros traded outside Europe are Euroeuros

 The 

rupee is not a freely convertible currency

E.g. If a bank in Dubai were to accept rupee deposits they would constitute Eurorupees 173 Copyright Tarheel Consultancy Services

Eurocurrency Markets  These

deposits need not be with European banks. Although originally most banks which accepted such deposits were located in Europe. 

E.g. Banks in Tokyo, Singapore and Hong Kong also accept dollar deposits. These are often called ‘Asian Dollar’ markets.

174 Copyright Tarheel Consultancy Services

Why Eurocurrency Markets? 

Why should a bank outside the U.S accept deposits denominated in U.S.D.? 1.

2.

3.

After World War II, the U.S. dollar became the preferred currency for global trade. Everyone wished to hold dollar balances. During the cold war, Warsaw Pact countries were reluctant to hold dollar balances with American banks. there was a fear that such deposits could be impounded by the U.S. government. But they needed such balances to finance imports European banks began to realize that such funds could be profitably lent out, and consequently began to accept such deposits. 175 Copyright Tarheel Consultancy Services

Eurocurrency Markets (Cont…)  One

of the significant reasons for the explosive growth of Eurocurrency markets was the existence of interest rate ceilings and high reserve requirements in the U.S.

 Under

a legislation called ‘Regulation Q’, the U.S. government imposed low interest rate ceilings on bank deposits and simultaneously specified high reserve limits 176 Copyright Tarheel Consultancy Services

Interest Rate Ceiling  An 

‘interest rate ceiling’ is easy to comprehend.

It precluded banks from paying interest at more than the stipulated maximum rate  Consequently



their ability to attract deposits diminished.

What is a ‘reserve’ and how does it work?

177 Copyright Tarheel Consultancy Services

Reserve  When

a bank accepts a deposit of Rs 100 in India, it cannot lend out the entire amount.

A

fraction of the deposit has to be maintained in the form of approved government securities and as cash with the RBI. 

This amount is known as a reserve.

 The

objective is to bolster the safety of the deposit holders. 178 Copyright Tarheel Consultancy Services

Should we set reserves at a high level?  Obviously

the higher the reserve percentage, the greater is the safety for the depositors

 On

the flip side, the higher the reserves, the lower is the income for the bank 

Government securities do not pay market rates of interest



It would be more profitable for the bank to lend the money locked up as a reserve to a borrower 179 Copyright Tarheel Consultancy Services

Should we set reserves at a high level?  The

issue is more serious when reserves have

to be kept in the form of cash. 

Cash reserves yield either nil returns or very low returns

180 Copyright Tarheel Consultancy Services

Reserves Statutory Liquidity Ratio (SLR): 25% of the deposit has to be maintained in the form of approved government securities

Cash Reserve Ratio (CRR): 4.5% of the deposit has to be maintained as cash with the RBI

181 Copyright Tarheel Consultancy Services

CRR  The

lower the CRR, the more the funds available

with the bank for productive lending 

If so, higher will be the rates offered on deposits, and lower will be the rates charged on loans.



Depositors and borrowers will both benefit.

 Recently

the RBI has started allowing interest on

CRR deposits

182 Copyright Tarheel Consultancy Services

Example - Reserves  Due

to high reserve requirements American banks could not offer attractive rates on deposits. 

‘Regulation Q’ made matters worse by imposing a ceiling on the deposit rate



At the same time they could not attract borrowers, because the lending rates were high.

 Consequently

European banks began attracting both lenders as well as borrowers leading to the growth of the Eurodollar market 183 Copyright Tarheel Consultancy Services

Lack of Regulations  Eurocurrency

deposits are outside the purview of the country to which the currency belongs 

E.g. The U.S. Federal Reserve cannot regulate Eurodollars

 There 

are no statutory reserve requirements

Even though there are no statutory requirements, banks do keep voluntary reserves as a measure of caution

 These

factors offer enormous flexibility to banks 184 Copyright Tarheel Consultancy Services

Petrodollars  There

was a war in the Middle East in 1973,

after which Arab countries began to use oil prices as an economic weapon 

Rising crude prices lead to large dollar balances with Arab countries

185 Copyright Tarheel Consultancy Services

Petrodollars (Cont…) 

Why Eurobanks could attract this money? 1.

There were no reserve requirements

2.

The transactions costs were low due to economies of scale.

3.

Thus Eurobanks could offer high interest rates to depositors

4.

At the same time could lend the funds at relatively low rates to borrowers 186 Copyright Tarheel Consultancy Services

Floating Rate Loans History

Today

Loans have been made on the basis of a fixed rate

The growth of the Eurocurrency market has lead to loans based on floating rates of interest

The interest rate remains The interest rates on such fixed for the tenure of the loan loans are not constant, but are linked to a benchmark. Consequently they vary with changes in the level of the benchmark. 187 Copyright Tarheel Consultancy Services

Example - LIBOR  The

most common benchmark - London Interbank Offer Rate (LIBOR) 

Rate at which a Eurobank is willing to lend to another Eurobank = LIBOR



Eurobanks will quote two rates for a currency –> bid & offer  Rate

at which a bank is willing to borrow = LIBID

 Rate

at which a bank willing to lend = LIBOR

 Average

of the above two = LIMEAN

 LIMEAN

is also sometimes used as a benchmark 188 Copyright Tarheel Consultancy Services

Example - LIBOR  Commercial

loans made on a floating basis are

priced at LIBOR plus a ‘spread’ 

The spread depends on the credit worthiness of the borrower



The more creditworthy the borrower, the lower will be the spread

189 Copyright Tarheel Consultancy Services

Basis Point  What

is a basis point?



A basis point is one hundredth of one percent



100 basis points = 1 percentage point

190 Copyright Tarheel Consultancy Services

Example  Loan

amt = $ 100,000  Interest payable -> semi-annually FIXED RATE LOAN  annual interest rate = 10%  Interest payable every six months = $ 5,000

FLOATING RATE LOAN  annual interest rate = LIBOR + 50 basis points (0.50%)  current LIBOR = 8% pa  Interest payable for the next six months:  (.08 + .005) x 0.5 x 100,000 = $ 4,250 191

Copyright Tarheel Consultancy Services

Example (Cont…) At end of six months: 

prevailing LIBOR = 8.5%,



interest for the following six monthly period:  (.085

+ .005) x 0.5 x 100,000 = $ 4,500.

 Interest

on the loan varies positively with the benchmark 

Higher the LIBOR higher will be the interest rate



Lower the LIBOR lower will be the interest rate 192 Copyright Tarheel Consultancy Services

contd determined in advance and paid in arrears: Interest is payable at the end of every six monthly period, but is based on the LIBOR that was prevailing at the beginning of the six monthly period determined in arrears and paid in arrears:

193 Copyright Tarheel Consultancy Services

International Bond Market  Borrowers

issue bonds in the international market to raise medium to long term funds. 



Borrowers  MNCs, governments, financial institutions. High Net Worth (HNW) investors use these markets for risk diversification

International Bond Market

Eurobond segment

Foreign bond segment 194

Copyright Tarheel Consultancy Services

Eurobonds  Bonds

denominated in one or more currencies

other than the currency of the country in which they are sold 

E.g. Bonds issued in currencies other than the Yen, which are sold in Japan, would be called Eurobonds. The issuer may be a Japanese or a foreign entity

195 Copyright Tarheel Consultancy Services

Eurobonds - Illustration  Sony

is issuing bonds in

 IBM

is issuing bonds in

Japan:

Japan: 

Issuer = Japanese company



Issuer = American company



Principal = $10 billion



Principal = $10 billion



Currency of issue = USD



Currency of issue = USD



Currency of Japan = Yen



Currency of Japan = Yen



196 Copyright Tarheel Consultancy Services

Foreign Bonds  Bonds

are issued in the currency of the country

in which they are sold  They

are issued by an agency from a foreign

country

197 Copyright Tarheel Consultancy Services

Foreign bonds - Illustration Foreign Bond

Not a Foreign Bond  Sony

is issuing bonds in

Issuer = Japanese company



IBM is issuing bonds in Japan:

Japan: 



Principal = 10 billion



Currency of issue = Yen



Currency of Japan = Yen



Issuer = American company



Principal = 10 billion



Currency of issue = Yen



Currency of Japan = Yen



198 Copyright Tarheel Consultancy Services

Foreign Bonds  Foreign

bonds have nicknames



U.S.  Yankee bonds



Japan  Samurai bonds



U.K.  Bulldog bonds



Australia  Kangaroo bonds

199 Copyright Tarheel Consultancy Services

Growth in Eurobond Markets 

Eurobond market provides lower yield, yet has grown more rapidly than foreign bond market: 1.

These bonds are not subject to the regulations of the country in whose currency they are issued 

1.

E.g. to issue US dollar bonds in Japan permission is not required from U.S. authorities

They can be brought to the market quickly and with less disclosure 

Important characteristic when an issuer wants to take advantage of favorable market conditions 200 Copyright Tarheel Consultancy Services

Growth - Eurobonds 3.

They are issued in ‘bearer’ form and offer favourable tax status by assuring anonymity 

The name and address of the holder are not mentioned on the bond certificates.



3.

In practice this has facilitated tax evasion and tax avoidance

Interest paid on such bonds is not subject to withholding taxes a.k.a. TDS in India

201 Copyright Tarheel Consultancy Services

History of Eurobonds 

Due to



Foreign



Investors

‘Regulation Q’,

companies

were flocking

U.S financial

were issuing

institutions

Yankee bonds

to these

could not offer

with relatively

high rates of

attractive rates

interest

of interest

Yankee bonds

202 Copyright Tarheel Consultancy Services

History of Eurobonds  1963 

U.S government imposed an interest equalization tax  To reduce the effective rate of interest from Yankee bonds for American investors  To prevent what was perceived as a flight of capital from the U.S.

 Post 

1963

As a result of the equalization tax, global issuers moved their dollar denominated borrowing programs to outside the U.S.  This lead to the growth of the Eurobond market 203 Copyright Tarheel Consultancy Services

Euronotes  Euronotes

or Euro Commercial Paper (ECP) are

similar to Eurobonds 

They are short term money market instruments with 1 to 6 months to maturity.

204 Copyright Tarheel Consultancy Services

Globalization of Equity Markets  Equity

markets have been slow to globalize as compared to debt markets

 Of

late the process has accelerated due to:



Worldwide deregulation of capital markets



Rapid developments in telecommunications



Greater awareness of the benefits of international portfolio diversification



Growing investor sophistication 205 Copyright Tarheel Consultancy Services

Major Regulatory Changes  1975:

The U.S dismantled the system of fixed

brokerage rates 

Now clients and brokers were free to negotiate commissions

 1985:

The Tokyo Stock Exchange (TSE) started

admitting foreign brokerage firms as members.  1986:

The London Stock Exchange (LSE)

eliminated fixed brokerage commissions. 206 Copyright Tarheel Consultancy Services

Regulatory Changes (Cont…)  1986:

LSE began to admit foreign brokerage houses as members. This event is known as the `Big Bang’ 







Objective: To give London an open / competitive international market London is ideally situated from the point of view of its development as a global market It is located in between the capital markets of North America, Singapore, Tokyo. It is the middle link for what is effectively a 24 hour market. 207 Copyright Tarheel Consultancy Services

Regulatory Changes (Cont…)  1987:

Financial institutions in London were

permitted to participate in both Investment as well as Commercial banking.  1999: 

This change was affected in the U.S.

Banks which undertake both commercial as well as investment banking operations are referred to as ‘Universal Banks’. 208 Copyright Tarheel Consultancy Services

Dual / Multiple Listing  Refers

to the listing of the shares of a company

on the markets of more than one country  This

offers many potential advantages to the

companies so listed

209 Copyright Tarheel Consultancy Services

Advantages of Dual Listing  Companies

must meet the securities market regulations of the foreign country and foreign stock exchange. This very often requires a company to comply with stringent disclosure norms  To list its shares on a U.S. exchange an Indian company has to comply with SEC and NYSE/Nasdaq requirements  It has to ensure that its accounts are in accordance with U.S. GAAP  For companies in developed countries, such compliance leads to greater transparency, which benefits the domestic shareholders 

210 Copyright Tarheel Consultancy Services

Advantages of Dual Listing  Foreign

listings provide MNCs with indirect advertising for their product brands

 It

raises the profile of the company in international capital markets 

Makes it easier for them to borrow or raise debt overseas

A

spread of shareholders across the globe reduces the threat of hostile takeovers. 211 Copyright Tarheel Consultancy Services

GDRs and ADRs 

Foreign equity is traded

Depository Receipts (DRs)

on international markets in the form of Depository Receipts.

Global Depository Receipts (GDRs)

American Depository Receipts (ADRs) 212

Copyright Tarheel Consultancy Services

What is an ADR? A 

special share of foreign equity priced in U.S.D. It is a DR issued to American investors on the basis of shares issued by a foreign entity



Each receipt  Represents ownership of a specific number of securities  These

would have been placed with a custodian bank in the

issuer’s country 213 Copyright Tarheel Consultancy Services

An ADR issue process India

India

Domestic shares

Custodial Bank

Wipro

SBI

Depository Bank

ADRs

USA

USA

JP Morgan Copyright of Tarheel Consultancy Bank New YorkServices

214

ADRs (cont…)  ADRs

can be packaged to ensure that they trade

at the appropriate price range in the U.S.  ADRs

can be a fraction/multiple of the

underlying foreign shares

215 Copyright Tarheel Consultancy Services

Illustration

India

USA

Domestic shares

ADRs

USA

Rs. 30 / share

60c /share

1 ADRs = 10 domestic shares $6 /share

216 Copyright Tarheel Consultancy Services

Fungibility  The

ability to interchange with an identical item

One way fungibility

Two way fungibility

The holder of an ADR can sell the Shares can be surrendered to the DR back to the depository depository in the home country and ADRs acquired in lieu depository will in turn have the equivalent number of shares sold in the home market

Less attractive from the standpoint Required to ensure that there are of an American investor no arbitrage opportunities between the U.S and the home market Has potential to reduce liquidity and the floating stock of DRs Copyright Tarheel Consultancy Services

217

Arbitrage  How  

will arbitrage work in the case of ADRs?

Assume that the ADRs are overvalued in the U.S. A trader in the U.S. can short sell ADRs in the U.S.  acquire shares in India  have them converted to ADRs and cover his short position in the U.S. USA

India

ADRs

Domestic shares

Overvalued hence shortsell

Buy in India Convert to ADRs 218

Copyright Tarheel Consultancy Services

Arbitrageur – Infosys ADR overvalued

USA

Exch rate Rs. 50/dollar

India

1 ADR = 10 domestic shares

Domestic shares

$210 / ADR

Rs.1000 /share Acquire 10 shares (-Rs.10,000) $200

Shortsell 1 ADR(+$210) Convert Profit = $10

219 Copyright Tarheel Consultancy Services

Arbitrage (Cont…)  What 

if ADRs are undervalued in the U.S?

An arbitrageur will buy ADRs in New York  surrender them to the overseas depository bank in exchange for domestic shares  and will then sell the domestic shares in India USA

India

ADRs

Domestic shares

Undervalued hence buy

Sell in India

220

Convert domestic shares Copyright to Tarheel Consultancy Services

Arbitrageur – Infosys ADR undervalued

USA

Exch rate Rs. 50/dollar

India

1 ADR = 10 domestic shares

Domestic shares

$190 / ADR

Rs.1000 /share

Buy 1 ADR(-$190) Convert

Sell 10 shares (+Rs.10,000) $200

Profit = $10 221 Copyright Tarheel Consultancy Services

ADRs - History  The

first ADR was created by J.P. Morgan in

1927. 

From the standpoints of clearing and settlement:  ADR

a domestic U.S security



Traded on NYSE, AMEX, Nasdaq, and OTC markets



1996: $13,655 billion worth of DRs were raised through 80 public offerings by companies from 80 countries. 222 Copyright Tarheel Consultancy Services

ADRs (Cont…)  Four 

levels of ADRs in the U.S.

They differ with respect to the amount of information that is required to be provided to the investors.



This therefore has implications for the level of access granted to the U.S. capital market.

223 Copyright Tarheel Consultancy Services

Levels of ADRs Levels of ADRs

Unsponsored ADRs

Sponsored Level-1 ADRs

Sponsored Level-2 ADRs

Sponsored Level-3 ADRs

224 Copyright Tarheel Consultancy Services

Unsponsored ADRs

Sponsored Sponsored Sponsored Level-I ADRs Level-II ADRs Level-III ADRs

issued by depositories in the U.S in response to market demand

do not require compliance with U.S. GAAP, or disclosure beyond what is required in the home country

require financial require even statements more paperwork conforming to U.S. GAAP, and disclosure in accordance with SEC regulations

issues are not initiated by the parent foreign company

can be traded on can be traded on allow issuance OTC mkts in the U.S. exchanges and sale of new U.S. and on shares to raise some exchanges equity capital in outside the U.S the U.S. 225 Copyright Tarheel Consultancy Services

Benefits to Issuers  Company’s

image is boosted at home and abroad  Stock prices are brought in alignment with international trends  Useful mechanism for raising capital in foreign exchange  Issuer does not bear the risk of exchange rate fluctuations,

- since dividends are paid to the domestic custodian bank in domestic currency

226 Copyright Tarheel Consultancy Services

Benefits to Holders  Get

access to assets which are quoted in

USD and trade like any U.S. security  Get

dividends in USD

227 Copyright Tarheel Consultancy Services

Why Globalization?  ‘Globalization’ has acquired a lot of prominence

over the past decade. 

Many countries have substantially deregulated their capital markets  E.g.

Big Bang at the LSE

 E.g.

1981: abolition of interest rate ceilings

 E.g.

1981: the creation of International Banking Facilities (IBFs) by the U.S govt. 228 Copyright Tarheel Consultancy Services

IBFs - Advantages 

It allows U.S. banks to use domestic branches to service foreign customers. 



The bank does not need to create a new physical infrastructure Only a different set of books to record the deposits/loans is required

IBFs can receive deposits from or make loans to nonresidents of the U.S., or other IBFs  IBF operations are not subject to reserve requirements / U.S. interest rate regulations / Federal Deposit Insurance Corporation premia 

229 Copyright Tarheel Consultancy Services

IBFs - History History

Today

To allow U.S. banks to compete effectively with offshore banks (Eurobanks) without having to set up an office offshore

Over 75% of the deposits are with IBFs located in New York State

California and Illinois are the other states with significant IBF activities 230 Copyright Tarheel Consultancy Services

Innovations  Another

major reason for increasing

globalization: 

The pace of innovations in financial products and services  New

products are regularly being created

 Innovative

techniques for risk management 231 Copyright Tarheel Consultancy Services

Innovations  To

quote Dembroski:

`A borrower can now issue fixed rate debt, in a currency and country of his choice, and by the time the deal is closed, he may have converted to a floating rate, switched to a different currency, and hedged away the exposure.’ 232 Copyright Tarheel Consultancy Services

Tech Advances 

Integration of financial mkts would have been infeasible without rapid advances in:   



Telecommunications Computer hardware Software

Links can be instantly established, & funds and securities can be transferred safely and quickly 



E.g. Reuters, Bloomberg, Telerate provide round the clock access to prices/news from financial centres across the world E.g. Most leading exchanges are now electronic and fully automated. 233 Copyright Tarheel Consultancy Services

Sophistication of Investors & Borrowers  MNCs,

HNW investors, & even Govts have become increasingly sophisticated  Corporate treasurers, fund managers, & bureaucrats are highly educated and aware  Markets these days are primarily dominated by institutional traders. 



Institutional players can afford to employ large teams of experts They can also take advantage of economies of scale 234 Copyright Tarheel Consultancy Services