Corporate Finance Reflective Week Assignment

By, Group No: 2 Paras Thukral Saransh Patni Asha Adisesh Karishma Thawani Poovaraghavan Selvaraj

Interest-rate Swaps Scream Buyer Beware

The Financial Services Authority found that some U.K. banks misled corporate customers in the sales of interest-rate swaps, but the problem is not confined to one country.

While few CFOs or treasurers would relish the idea of boning up on interest-rate swaps, it now seems as if someone in the finance department ought to. Many businesses may have been misled about the costs and risks of interest-rate hedging products they bought from U.K. banks in the past decade, according to a preliminary review by the countrys Financial Services Authority released Thursday. In particular, the FSA found instances in which nonfinancial businesses it classifies as unsophisticated buyers were persuaded that they had to buy an interest-rate swap when they took out a loan, and many were unaware of the exorbitant costs of cancelling an over-the-counter swap contract with a bank. But experts say the sales practices that violated U.K. laws have occurred and may still be occurring worldwide including in the United States. Some examples: an Indian property developer, Unitech Ltd., sued Deutsche Bank AG last May for selling an interestrate swap that Unitech says wasnt explained properly. Jefferson County, Alabama, barely avoided bankruptcy after entering into $5.6 billion of swap trades in which the fees were embedded in the interest rates the county paid, hiding the fact that the county was substantially overcharged by its bank. Many companies, including U.S. businesses, are buying interest-rate hedges, usually in conjunction with borrowing that they just dont comprehend, cant value, and that contain hidden fees and risks. I think the end-user can enter into a deal without fully understanding it, and I have seen situations like this over the years, says Gurpreet Banwait, product manager at derivatives risk-management firm FINCAD. Im no longer surprised at [the deals] people execute. Interest-rate swaps which financial-services providers consider relatively simple instruments arent always that simple for end-users to fathom. To a borrower, a swap instrument may look good because there are no upfront fees or even perhaps a positive return. But this is usually achieved through complexity that only the seller truly understands, says Banwait. As part of a pilot study of the sale of 40,000 interest-rate hedging products over a decade, the FSA said it looked at 173 swap sales to non sophisticated customers from four banks: Barclays Bank Plc, HSBC Bank Plc, Lloyds Banking Group, and the Royal Bank of Scotland. It found that more than 90% of the sales did not comply with one or more U.K. regulatory requirements regarding sales practices, such as the failure to ascertain the customers understanding of risk. Instances of over hedging where a swaps amount or duration does not match the underlying loan were also found.

In other deals, borrowers were misled into thinking that buying a hedge was mandatory. The FSA found an instance in which a business that didnt want to buy an interest-rate hedge was told by the bank that it was a requirement of their loan that they purchase the product. Break, or exit, costs were another area of confusion. When exiting a swap, the customer or the bank may have to make a payment to the counterparty, depending on market conditions. But the FSA found that in a high proportion of swap sales, customers werent given enough information to figure out the cost of exiting. We saw examples in the pilot where the break cost exceeded 40% of the value of the underlying loan, the FSA said in its report. In one case, a business purchased a swap in which the bank had the option to exit the deal after five years. The customer said it was misled into believing it too could exit the contract after the same time period without any costs when this was not the case, said the FSA. In the United States, of course, exiting a bilateral swap is just as costly and complex. To get out of such a swap, a company would have to sell the swap back to the bank, offload it to a third party, or enter into a swap that offsets the original instrument. In general, terminating an [OTC] swap creates difficulty, friction, and increased costs, Sean Tully, head of interest rates at CME Group, told CFO last December.

Key terms: Interest Rate Swap: An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap.

Hedge: Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

Over-Hedging : A hedged position in which the offsetting position is for a greater amount than the underlying position held by the firm entering into the hedge. The over-hedged position essentially locks in a price for more goods, commodities or securities than is required to protect the position held by the firm.

Analysis: An interest rate swap is a mutual agreement between two financial organizations to exchange streams of interest payments, over a fixed period of time. Swaps are derivative contracts and trade overthe-counter. Here in this article, we found out that these swaps although legal as per the UK and US laws (regularized by governments) still have loopholes and violate one law or another. Here with these firms fixed income investments, interest-rate swaps associate two major risks: interest rate risk (varies with market) and the credit risk (the risk associated with the borrower). Since actual interest rate fluctuations are not always at par with the expectations, swaps involve interest-rate risk. Having put simply with reference to the cases in this article, the receiver is getting profits if interest rates fall and loses if interest rates rise. Conversely, the payer gets profits if rates rise and loses if rates fall. At the time a swap contract is put into place, it is typically considered at the money, meaning that the total value of fixed interest-rate cash flows over the life of the swap is exactly equal to the expected value of floating interest-rate cash flows. In many of the cases mentioned in the article, one counterpart of the deal is mislead and is not aware of the deal. This further has lead to violation of one or two clauses in the contract causing loss to either of the party. Moreover, to get out of such swaps is complicated and very complex. This mis-selling of swaps can be controlled by more stringent regularization of the derivatives market and precise clauses being mentioned in the contract.

References:

Capital Markets : CFO. (n.d.). Retrieved from CFO Web Site: http://www3.cfo.com/article/2013/2/credit_interest-rate-swaps-fsa-otc-overhedging-break-cost-cftcsec?currpage=2 Hedge: Investopedia. (n.d.). Retrieved from Investopedia Web Site: http://www.investopedia.com/terms/h/hedge.asp#axzz2K8vZ3V3p

Interest Rate Swap: Investopedia. (n.d.). Retrieved from Investopedia Web Site: http://www.investopedia.com/terms/i/interestrateswap.asp Over Hedging: Investopedia. (n.d.). Retrieved from Investopedia Web Site: http://www.investopedia.com/terms/o/overhedging.asp#axzz2K8vZ3V3p

Key terms: Tax-free bond: A tax free bond or a tax exempt bond is one which is not subjected to any kind of federal tax, income tax for the gains from the bonds. It is usually issued by a municipal, state or central government for doing improvements in infrastructure Over subscription: It is a situation in which the initial public offering (IPO) price is set equal to the security price. But the demand for the subscription has exceeded the level from the expected level. The firm can increase their capital inflow by increasing the price at this stage and then bring the oversubscription to equilibrium Redeemable, non-convertible bond: Redeemable bond is otherwise called as a callable bond. It is a bond in which the issuer has the rights to redeem the bond before the maturity date, under certain conditions. While redeeming, the issuer pays a higher price for the investor to compensate for the loss. A non-convertible bond is one in which there is no option of converting the bond into normal stock. Hence the interest rate of a non-convertible bond is usually lower due to the lower risk involved in the bond. Non-performing assets (NPA) company: It is a type of classification of loans by the financial institutions, according to which the loan is in the verge of default. Any loan for which the borrower has failed to pay the interest for 90 days continuously is said to be a nonperforming asset. Analysis: Face value = Rs. 1000 Tenure (short period) = 10 years; Interest (short period) = 7.18% p. a; Tenure (long period) = 15 years Interest (long period) = 7.34% p. a

Last recorded benchmark rate in market by RBI = 7.75% PV of 10 year bond = PV (7.75%, 10, 71.8, 1000, 0) = Rs 961.32 PV of 15 year bond = PV (7.75%, 15, 73.4, 1000, 0) = Rs 964.36

From the article it is evident that the capital is collected to finance the acquisition of the rolling stocks used in railway industry. In Indian scenario, railway is an ever growing industry serving the needs of a common man. Even when there is increase in price of tickets and services, people consider this mode of transport to be economical compared to the other modes. Thus it is certain that the investment is sure to provide a certain income and the credibility is given by the CRISIL as AAA which is said to be the most safe and least credit risk rating. The confidence of the investor is further gained by the key financials given by the Managing director of IFRC who said, We are a zero NPA (non-performing assets) company and have been growing at a compounded annual growth rate (CAGR) of 21 per cent Disadvantage of investing: In case if the investor needs his money back, the bonds can only be sold through secondary markets. The investors who are going to buy from the secondary markets may get it at a less interest rate which makes it less liquid. Also the bonds issued are a callable bond and so we may not be sure of when the company might redeem its bond. There might be a case where the industry sees a tremendous growth and it wishes to redeem the bond and issue at a lower price. Though there is an evident growth the investor does not enjoy the growth. Had he invested the same amount in stock market, it may result in a never ending dividend, unless the investor wants to quit the stock market. References: 1. https://www.investopedia.com 2. Wall street journal Europe edition : http://europe.wsj.com/home-page 3. http://www.tradingeconomics.com/india/government-bond-yield 4. http://www.thehindu.com/business/Economy/taxfree-bonds-from-irfc/article4309953.ece

Dubai bond sale set to spur credit markets

posted on 26/01/2013:

The ease with which Dubai was able to tap bond markets this week will act as a catalyst for a string of companies looking to raise debt as demand for credit from the region shows little sign of cooling off among international investors. However, analysts warn that Dubai is benefiting as much from investors hungry for returns in markets awash with cheap funding as from a belief in its recovering fundamentals. The US$1.25 billion (Dh4.59bn) sale of bonds and sukuk debt by the Government of Dubai closed in one day as the full details were announced on Wednesday. A $750 million tranche of 10-year sukuk paying a coupon of 3.875 per cent represented a lower rate than the Italian government pays on its 10-year debts. An additional 30-year bond sale was also requested by institutional investors, marking a first for the emirate. "The numbers speak for themselves," said Georges Elhedery, the head of global markets at HSBC, one of the banks that arranged the deal. "The tight pricing, tenor and speed of execution demonstrate international investors' confidence in Dubai's credit." Global emerging market bonds are being snapped up by investors as a result of low or negative yields available in developed markets, said Daniel Broby, the chief investment officer at Silk Invest, an investor in frontier markets. "Things are bit frothy at the moment," he said. "Right now, we've got a risk-on environment. As a result, even Angola can tap the debt markets." Yesterday, investors even witnessed the return of the troubled euro-zone member Portugal to bond markets for the first time since its bailout by the European Union in 2011. However, historic low interest rates around the world coupled with the perception that the worst of the financial crisis has passed was resulting in some corporate credit in Dubai becoming mispriced, added Mr Broby. "Anything with any form of yield at all is being bid up right now," he said. "It's time for caution." There are still unresolved issues with Dubai Government related debt which could cause concerns for investors should they re-emerge, added Mr Broby. The re-emergence of geopolitical tensions in the region, such as between Iran and Israel, had put paid to market rallies in the past and convinced investors to dump Arabian Gulf debt, said William Jackson, an emerging markets economist at Capital Economics. "In the past it has led to higher bond yields and a spike in credit default swaps when tensions have risen," he said. This effect was hard to predict given the amount of liquidity currently available in the financial system, added Mr Jackson. Yields on Dubai's 10-year bonds rose by 42 basis points yesterday to 3.754 per cent, the first increase in

yield in six weeks. Bond yields move in the opposite direction from prices. Because of the dirham pegging to the US dollar, the Central Bank is unable to raise interest rates and must instead follow the lead of the Federal Reserve, which is expected to hold rates at historic lows throughout the year. Moves by the European Central Bank, expected to begin winding down some of its crisis-era capital injections to lenders later this month, could also contribute to a tightening of credit extended to Gulf corporates, said Mr Jackson. "They'll probably maintain exposure to the region, but it could make it a bit more difficult," he said. Deutsche Bank estimates that Dubai has $9bn of debts due for refinancing in the year ahead, equivalent to 7 per cent of GDP. "Significant amounts of debt will mature in 2014-15, partly as a result of earlier debt restructuring," analysts from the investment bank said in a report last week. Yet the Dubai Government's moves in the bond market may open the door for a number of corporate debt issuances. Emirates Airline is planning to go to market with a benchmark dollar bond, Reuters reported this week. A benchmark bond is typically around $500m in size. Dubai Electricity and Water Authority, also known as Dewa, is also said to be planning a $1bn sukuk sale this year. Dubai's Department of Finance has stated that the bond and sukuk sale helps contribute to two of the emirate's long-term policy goals: the creation of a centre for Islamic industries, and development of a yield curve for domestic debt. "The Sukuk offering compliments with the vision of His Highness Sheikh Mohammed bin Rashid Al Maktoum, Vice President and Prime Minister of the UAE and Ruler of Dubai, to establish Dubai as the global capital of Islamic finance while the 30-year bond completes the yield curve for Dubai and matches the long term project requirements of the government," it said. A yield curve, consisting of many different bonds of different maturities, serves as a pricing benchmark for other companies seeking to issue debts. The UAE's financial services industry has advocated the development of a yield curve as a means of improving market liquidity and enabling more companies to go to market. "If Dubai wants to be taken seriously it really needs to have that as part of its arsenal," said Mr Broby. The National

http://www.uaeinteract.com/docs/Dubai-bond-sale-set-to-spur-credit-markets/53080.htm

Analysis: The article dated 26th January, 2013 enumerates how a positive drive is being created in the Dubai credit market as the countrys bonds are being sold. The Government of Dubai was able to sell bonds and Sukuks (An Islamic financial certificate similar to a bond in western finance) worth US$1.25 billion (Dh4.59bn) which goes to indicate that this would act as a catalyst to attract international investors to companies in Dubai. A $750 million tranche of a 10-year sukuk paying a coupon of 3.875 per cent represented a lower rate than the Italian government pays on its 10-year debts. An additional 30-year bond sale was also requested by institutional investors, marking a first for the emirate. This is proof of the fact that investors are seeking to invest in this region. HSBC was one of the banks that arranged the deal. George Elhedery, the head of Global Markets at HSBC clearly points out that the tight pricing of the bonds, mood and the speed of execution indicate that investors rising confidence in Dubais credit market. Investors are eager to capture bonds in emerging markets as developed markets are offering very low or negative yields. Even a country like Portugal which is now recovering from the Eurozone crisis has returned to the bond markets recently, since its bailout by the European Union in 2011. However, there are some unresolved issues about Dubai Government and the UAE which might affect investors in the long run. When geo-political tensions in the Gulf region such as between Iran and Israel, it leads to higher dividend yields and lowers investor confidence for the region. Deutsche Bank estimates that Dubai has $9bn of debts due for refinancing (The replacement of an existing debt obligation with a debt obligation under different terms) in the year ahead, equivalent to 7 per cent of GDP. A significant amount of the debts mature in 2014-15, as a result of the restructuring of debt. In spite of the heavy debts, the governments moves in the bond markets would open doors of opportunities for the corporate credit market in Dubai. For instance, Emirates airline is planning to go to market with a benchmark dollar bond of around $500 million. A benchmark bond is a bond that provides a standard against which the performance of other bonds can be measured. The comparison happens across bonds which have similar liquidity, coupon and issue size. However, the sale of Sukuks and bonds in Dubai market is primarily in view of UAEs long term goal which is to develop a yield curve for domestic debt. A yield curve, consisting of many different bonds of different maturities, serves as a pricing benchmark for other companies seeking to issue debts. It encourages more number of corporate in the region to seek credit. So to conclude with, from the article we see that Dubais entry into bond market acted like means to improve the credit seeking potential of various companies. The investors are interested in investing in the country in spite of some hitches like political issues. In spite of large debts in the region already, investors are still seeking to invest here due to the prospects of obtaining a good yield as Dubai is an emerging market.