Lect 5 - FM&I - Cap Mkt Instruments

8/13/2019 Lect 5 - FM&I - Cap Mkt Instruments

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Milind S Limaye


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Broad categories

A) Direct

Equity / Ordinary shares

Preference SharesDebenture / Notes

Innovative Debt Instruments

B) Derivatives

Forwards

Futures

Options

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Values related to Equity / Ordinary shares

Face value

Issue price

Share premium

Book Value

Market value

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Features

1) Residual claim to income the income left after paying expenses, interest charges, taxes,

preference dividend, if any. Usually, a part of the residual incomeis distributed in the form of dividend to the shareholders andother part called retained earnings is reinvested in the business.

2) Residual claim on assets In case of liquidation of the company, equity shares are the last

ones to be paid. They are paid after the claim of preferenceshareholders have been satisfied. In case of liquidation due to badfinancial state of affairs, the equity shareholders generallyremains unpaid

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3) Right to control

Right to control here means the power to take decisions, framemajor policies and power to appoint directors. Equity shareholdershave the legal power to elect directors on the board and also to

replace them if the board fails to protect interest of theshareholders.

4) Voting rights

Each equity share carries one vote. Directors are elected in the

annual general meeting by the majority votes. Thus, everyshareholder can participate in the vital affair of election ofdirectors and cast his vote depending on the number of sharesheld by him.

5) Limited Liability

In a company limited by shares, an equity shareholder's liability islimited to the amount of investment in his respective share. If hisshares are fully paid up, he doesn't have to contribute anything inthe event of financial stress or winding up of his company.

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Merits

1) Permanent source of funds without repaymentobligation

2) It does not involve obligatory dividend payment

3) It forms the basis for further long term financing asit indicates creditworthiness

4) For shareholders with limited liability, they exercisecontrol and share other ownership rights in income /assets of the company

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Demerits

From the point of view of company

High cost of funds

High flotation cost Control on company by majority of shareholders

From the point of view of shareholders

Risky investment No assurance of fixed ROI, Noright to claim Dividend

No effective and real control

Wide fluctuation in share prices

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In brief, equity share capital is a high risk high reward,permanent capital market instrument / source of longterm finance for corporate enterprises.

Shareholders who desire to share risk, return andcontrol associated with ownership of companies wouldinvest in corporate equity.

For the corporate, it is a source of long-term fund, with

high cost, low risk/ nil risk without any dilution ofcontrol and restraint on managerial freedom.

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Preference Shares This is a unique type of long term capital market instrument,

which combines some of the features of equity shares as wellas some of debentures.

It has attributes of Equity capital such as dividend is paidout of divisible / NPAT and is non tax deductible, payment ofpreference dividend depends on discretion of management,irredeemable types of preference shares have no fixedmaturity date

It has attributes of Debentures such as it has fixed / statedrate of dividend, ranks higher than equity as a claimant to theincome /assets, normally does not have voting rights

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Features / Attributes

Prior claim on Income / Assets

Preference shares have a prior claim on the company's income/dividendsduring its life time and prior claim on the assets of the company in theevent of liquidation.

Redemption

Redeemable preference shares are those which have a specified maturitydate whereas irredeemable preference shares are permanent or perpetualwhich are payable only in the event of winding up of a company.

Fixed Dividend

The dividend rate paid to the preference shareholders is fixed anddividends are not tax deductible also.

Voting rights

Preference shareholders have no voting right but they are granted votingright if the company skips preference dividend for three years.

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Merits

To investors

Assurance of a stable dividend

Preference in dividend payout over dividend paid toequity shareholders

To corporate

No legal obligation to pay preference dividend

Redemption can be delayed without significantpenalties

Forms part of net worth

No dilution of control Milind S Limaye


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Demerits

High cost

Modest dividend in the context of associated risk

In brief, preference share / capital involves

i) high cost,

ii) does not dilute control,

iii) has negligible risk, andiv) puts no restraint on managerial freedom

It is however, not a popular capital market instrument in

India Milind S Limaye


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Debentures / Bonds - Debentures and Bonds represent creditorship securities

and Debenture holders / Bondholders are long termcreditors of the company

These are fixed income (interest) securities.

Features / Attributes

1) Trust Indenture / Deed

2) Interest

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3) Maturity

4) Debenture Redemption Reserve

5) Call and Put provision

6) Security

7) Convertibility

8) Credit rating

9) Claim on income /assets

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Merits -

For corporate -

Lower cost due to lower risk and tax deductibility of interest

payment No dilution of control as holders do not have voting rights

For investors

Stable return Fixed maturity

Enjoy preferential claim

Protected by trust deed

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Demerits

Restrictive covenants in Trust Deed

Legally enforceable contractual obligation in respect ofinterest payment and repayments

Increased financial risk

No voting rights

Debenture prices are vulnerable to change in interestrates

In short, debentures as long term source of funds /capital market instrument have low cost, do not dilutecontrol, involve high risk and put some restraint onmanagement freedom

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Innovative Debt Instruments / Securities A) Convertible Debentures / Bonds It gives the holder right (option) to convert them into

equity shares on certain terms.

They are entitled to a fixed income till conversionoption is exercised and would share the benefits

associated with equity shares after the conversion.

All the details about the conversion terms i.e.conversion ratio, conversion premium / price andconversion timing are specified in offer document.

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Companies can issue Fully Convertible Debentures

(FCDs) or Partly Convertible Debentures (PCDs)

No. of ordinary shares for each CD is conversion ratio

The conversion price is the price paid for ordinaryshares at the time of conversion.

The conversion time refers to the period from the dateof allotment of CDs after which the option to convert

can be exercised.

If the conversion is to take place between 18 to 36months, the holder will have the option to to exercisehis right in full or part.

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A conversion period exceeding 36 months is not

permitted without Put or Call option

Compulsory credit rating is necessary for fullyconvertible debentures

Three types of CDs are presently available in India:

i) Compulsorily convertible within 18 months

ii) Optionally convertible within 36 months

Iii) Convertible after 36 months

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Valuation of CCDs The holders of PCDs receive

interest at a specified rate, over the term of debenturesplus equity shares on part conversion and repayment ofuncovered part of the principal.

Value of OCDs it depends on three factors i) StraightDebenture Value (SDV), Conversion Value (CV), OptionalValue (OV)

Merits

i) CDs improves the cash flow matching of firms

ii) It generate financial synergy

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C) Warrants A warrant entitles its holders to subscribe to the equity

capital of a company during specified period at a specified /particular / certain price. The holder acquire only the right i.e.option but has no obligation to acquire the equity share.

Warrants are generally issued in conjunction with / tied toother instruments, e.g. attached to i) secured premium notesand ii) Debentures. It can be issued independently also.

Warrants are similar to CDs to the extent that both gives the

option / right to buy ordinary shares. While the debenturesand conversion option are inseparable, a warrant can bedetached. Similarly, the conversion option is tied with thedebentures but warrants can be offered independently.

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Features of Warrants

Exercise price

Exercise Ratio

Expiry date

D) Zero Interest Bonds / Debentures Also known as Zero coupon bonds / debentures, ZIBs do

not carry any explicit / coupon rate of interest. They aresold at a discount from their maturity value. The differencebetween the face value of the bond and the acquisitioncost is the gain / return to investors

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Acquisition price = Maturity (face) value / (1+I)n

E) Deep Discount Bonds - It is a form of ZIB. It is issued at a deep / steep discount

over its face value. The DDB appreciates to its face valueover the maturity period.

DDBs are being issued by the public financialinstitutions in India such as IDBI, SIDBI etc.

In 1992 IDBI sold a DDB with face value of Rs.1 lac at adeep discount price of Rs.2,700/- with a maturityperiod of 25 years.

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If the investor could hold the DDB for 25 years, theannualised rate of return would work out to 15.54%.The investor had an option to withdraw (put option) at

the end of every five years with a specified maturity /deemed face value ranging between Rs.5,700/- (after 5years) and Rs.50,000/-(after 20 years). Investors alsocould sell the DDBs in market. IDBI also had an optionto redeem them at the end of every 5 years, presumably

to take the advantage of prevailing interest rates.

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F) Secured Premium Notes SPN is a secured debenture redeemable at a premium

over the face value / purchase price. It resembles ZIB.

There is a lock in period for SPN, during which nointerest is paid. The holder has the option to sell SPNback to the issuing company, at par, after the lock inperiod. The redemption is made in installments. It is atradable instrument.

In case of ZIB payment is made in lump sum onmaturity, in case of SPN payment is spread over numberof years.

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G) Floating Rate Bonds FRBs) The interest on such bonds is not fixed.

It is floating and is linked to a benchmark rate such as

interest on T Bills, bank Rate, maximum rate of termdeposits. It is typically a certain percentage point higherthan the benchmark rate.

The price of FRBs tend to be fairly stable and close to

par value in comparison with fixed interest bonds.

They provide protection against inflation risk toinvestors.

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Forward ContractsA forward contract is an agreement to buy or sell anasset on a specified date for a specific price.

One of the parties to the contract assumes long positionand agree to buy the underlying asset on a certainspecified future date, for a certain specified price.

The other party assumes a short position and agrees tosell the asset on same date for the same price.

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Other contract details like delivery date, price and

quantity are negotiated bilaterally by the parties to thecontract.

It is normally traded outside stock exchanges. Mostlytraded in OTC market.

Salient features:

Since FC are bilateral contracts, it is exposed to

counterparty risk

Each contract is customer designed and hence is uniquein terms of contract size, expiration date and asset typeand quality

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The contract price is generally not available on public

domain

On expiry date contract has to be settled by delivery ofthe asset

If a party wishes to reverse the contract, it has tocompulsorily go to the same counterparty, which oftenresults in a high price being charged.

Forward contracts in forex markets have become verystandardised, thereby reducing transaction cost andincreasing transaction volume.

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FCs are useful in Hedging and Speculation

Hedging for Exporters and Importers

Speculation for the speculators

Limitations of FC

Lack of centralisation of trading Liquidity

Counterparty risk

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Futures terminology -

Spot Price The price at which an instrument / asset istraded in the spot market

Future price The price at which the future contracts are

traded in future market

Contract cycle The period over which a contract trades.Index future contracts typically have one month, two

months and three months expiry cycles that expires on thelast Thursday of the month

Expiry date It is the last day on which the contract will betraded, at the end of which it will cease to exist.

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Contract size It is the amount of the asset that has to be

delivered under one contract. E.g. contract size of NSEfuture is 200 Nifties

Basis It is defined as the future price minus the spotprice. There will be a different basis for each delivery

month for each contract. In a normal market, basis will bepositive.

Cost of carry It measures the storage cost plus theinterest that is paid to finance the asset, less the incomeearned on the asset

Initial margin It is the amount that is deposited in marginaccount at the time of futures contract is first entered into.

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Marking to market At the end of each trading day, themargin account is adjusted to reflect the investorsgainor loss depending upon the futures closing price. Thisis called as marking to market.

Maintenance margin This is lower than initial margin.It is set to ensure that the balance in margin accountnever becomes negative. Top needs to be done beforenext trading day.

Pay off for futures It is the likely profit / loss thatwould accrue to a market participant with change in theprice of underlying asset.

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Pay off for Buyers of futures Long futures

Pay off for Seller of futures Short futures

Pricing Futures The cost to carry Model

F = S + C OR

F = S (1+r)T

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The spot price Jan 1, year 1, of silver is assumed to be

Rs.7000/kg. Assuming the annual cost of financing of 15%and no storage cost, the fair value of the future price of 100gms of silver one month (Jan 30, year1) would be:

F=S(1+r)T

Rs.700(1+0.15)*30/365 = Rs.708/-

If the contract is for a three month period expiring on March30, year 1, the cost of financing would increase the future

price i.e.

F= Rs.700 (1.15) * 90/365 = Rs.724.50

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Pricing Equity Index Futures

The pricing of index futures is also based on the cost ofcarry model, where the carrying cost is the cost offinancing the purchase of the portfolio underlying he

index, minus the present value of dividends amount)obtained from the stocks in index portfolio.

If dividend flow throughout the year is generally

uniform, pricing under given expected dividend yieldcan be arrived.

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Pricing stock futures

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

Lect 5 - FM&I - Cap Mkt Instruments

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