Mfi 01

Tarheel Consultancy Services
Corporate Training and Consulting
1 Copyright Tarheel Consultancy Services
Part-01
Financial Systems Institutions, Instruments & Markets
Role of an Economic System
Role of an Economic System (Cont)

Collect savings and allocate them efficiently
PHRASE
Efficient Allocation

Efficient and free flow of funds between economic units is critical
The larger the flow and more efficient the allocation
Greater the likelihood of accommodating everyones preferences
Consequence
Greater the output of the economy as a whole
Economic Decisions
Economic Decisions (Cont)

Production of
Goods and Services
Distribution of the output
Economic Decisions (Cont)

What is a successful economy?
One that maximizes wealth creation One that makes and implements sound economic decisions
From what standpoints?
Production and Distribution

Why the focus on efficiency?
Unlimited wants Limited and scarce resources

What does efficiency require?
INFORMATION

What kind of economic information?
What do people need How best can goods and services be produced How best can the resultant output be distributed

Types of Economic Systems
COMMAND Economies FREE MARKET Economies
Command Economies
Command Economies (Cont)

All decisions are taken by
A CENTRAL PLANNING AUTHORITY
Role of the planner

Estimate the resource requirements of economic agents Rank them in order of priority Allocate resources in descending order of need

Why failure?
Infeasible to process the required quantum of information Poor quality of information Central planner was supposed to be a `BRIHASPATI Blatant political interference
Market Economies
Market Economies (Cont)

Make the most profitable use of resources
Profit is determined by
Prices of inputs COSTS Prices of outputs REVENUES
Optimal decision is the one that

MAXIMIZES PROFITS

Decision making is decentralized
Every agent has a required ROI (Return on Investment) Minimum return = Cost of Funds Critical inputs for decision making - PRICES

How is informational accuracy of the pricing mechanism ensured?
By markets that facilitate trade

If price is low
Demand > Supply Price will be bid up till equilibrium is reached
If price is too high

Supply > Demand Prices will decline till equilibrium is restored

What is equilibrium?
Differing perceptions of value will lead to supply demand imbalances The adjustment process will ensure that
SUPPLY = DEMAND Prices accurately convey value
Barter
Barter (Cont)
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
Barter (Cont)
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.
Barter (Cont)
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
Example of Barter
Telecom switches
AT&T
Telecom company USA seller Currency & Apatite
Sevtelecom
Telecom company Russia buyer
Apatite Currency
Helm AG
Trading Firm Germany
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Buyer & Seller
Money & Markets
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
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

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Money and Prices

Advantage of money
Reduces the number of prices required
Consider a 10 good barter economy

We would need 45 prices
However if we had a unit of currency

We would require only 10 prices
Markets
Services
Goods
MARKETS
Physical Assets
Financial Assets
Categories of Economic Units

Economic Units transacting in financial markets
Government Sector
Business Sector
Household Sector
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Government Sector
Government Sector (Cont)

Central/Federal government State governments Local governments a.k.a Municipalities
Business Sector
Business Sector (Cont)

Sole proprietorships Partnerships Private Limited Companies Public Limited Companies
Household Sector
Income and Expenditure

Income = Expenditure
Balanced Budget Units (BBU)

Income > Expenditure
Surplus Budget Units (SBU)

Income < Expenditure
Deficit Budget Units (DBU)

Function of a Financial System

funds
SBU
claim e.g. household sector
DBU
e.g. government business entities nation as a whole

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Economys Relationship with ROW

Record of transactions between a country and the Rest of the World (ROW)
Is known as the Balance of Payments (BOP)
Balance of Payments
Is a record of a countrys trade in
Goods Services Financial Assets
Balance of Payments (Cont)

BOP is divided into three major categories of accounts
The Current Account The Capital Account The Reserve Account

The Current Account
Is a record of Imports and Exports of goods and services
The Capital Account

Is a record of transactions that lead to changes in
Foreign assets and Foreign liabilities

The Reserve Account
Also deals with financial assets and liabilities But deals only with reserve assets
What are reserve assets?

Those used to settle deficits and surpluses on account of current and capital accounts taken together Assets acceptable as a means of payment in international transactions Assets held and exchanged by monetary authorities

The BOP must always balance
A current account deficit must be matched by
A capital account surplus (increase in foreign liabilities) Or by a depletion of reserves

Important sub classifications of BOP
Balance of Trade Current Account Balance
IMPORTS
EXPORTS
BALANCE OF TRADE
IMPORTS > EXPORTS = Trade Deficit (Net borrower from abroad) IMPORTS < EXPORTS = Trade Surplus (Net lender and invest abroad)
Current Account Balance

Balance of Trade pertains to merchandise imports and exports The current account balance is the sum total of
Exports of goods, services and income Imports of goods, services and income Net unilateral transfers
Financial Assets
What is an asset
a claim against the income or wealth of
a business a household Or a government agency
Financial Assets (Cont)

Manifestation of assets
Certificates Receipts Computer record files
Financial Claims
funds
SBU
claim
DBU
debt instrument
equity shares
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Why de we require financial assets?
Properties of Financial Assets
Serve as a store of value
Promise future returns
They are fungible
Liability
funds
SBU
claim
DBU
ASSET
LIABILITY
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Asset Classes
Money Equity shares Debt securities Preferred shares Foreign exchange Derivatives Mortgages and mortgage-backed securities
Money
Money (Cont)
Money is very much a financial asset
It is not just notes and coins One of the largest components of money
The checking account balances held by depositors with commercial banks
Money (Cont)
New Avataars of money
Credit cards Debit cards Smart cards
Money (Cont)
Functions of money
Unit of account
Every good or service can be denominated in terms of it
Medium of Exchange
It is the only financial asset that is always acceptable as mode of payment
Store of value
It is a reserve of future purchasing power
It is liquid
Liquidity
What is a liquid asset?
Can be quickly converted to cash with little or no loss of value
Why is liquidity important?

Enables transactions at prices that are close to the fair value of the asset
Otherwise buyers would have to offers a large premium Sellers would have to offer a large discount
Liquidity (Cont)
In a liquid market plenty of buyers and sellers will be available
Such markets are said to have Depth
Attributes of liquid assets

Price stability Ready marketability Reversibility
Liquidity (Cont)
There is a cost to liquidity
The more liquid the asset the lower is the rate of interest Interest foregone is lost for ever
Money is the most perishable of assets
Illustration of Perishability
Assume we have 100MM dollars in cash If the rate of interest is 3.6% per annum
Income foregone in a week is: 100,000,000x0.036x7/360 = $70,000
Equity
Equity Claims
funds
SBU
Ownership or equity shares
Claim on profits Assets remaining after debtors have been paid
DBU
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Equity shares or shares of common stock represent ownership in a business enterprise
shares
dividends part owner Business enterprise

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Dividends
The rate of dividends is not fixed It is not contractually guaranteed Dividends can fluctuate from year to year A company is under no obligation to declare dividends Good companies try to keep dividends at steady levels
Retained earnings
A firm will not pay out its entire profits for the year as dividends A fraction 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.
Equity (Cont)
Equity shares never mature - they have no expiry date.
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.

They can vote on various issues at the Annual General Meetings of companies, including the election of the board of directors.
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.
Equity (Cont)
Shareholders have Limited Liability
Unlike a sole proprietorship Or a partnership
What does this mean?

Creditors cannot make financial demands on the shareholders The maximum loss for a shareholder is limited to his investment
Debt
Debt Claims
funds
SBU
debt instrument or IOU
Pay interest at periodic intervals Repay principal at Copyright Tarheel Consultancy Services maturity
DBU
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Short term debt instruments
Types of debt instruments
Long term debt instruments

Long term debt securities

Have a time to maturity of one year or more Issued by the government or by corporations Bond
Firms also issue debt securities for which specific assets are designated as collateral. Secured debt
Debenture
In the U.S a debenture is a bond for which no assets of the firm have been specified as collateral. Unsecured debt
Note: In India the terms bonds and debentures are used interchangeably and thus could refer to secured as well as unsecured debt
Debt notes issued by the U.S. Dept of Treasury

long term 10 30 years medium term
time to maturity
T-bonds
time to maturity
T-notes
1 10 years short term

time to maturity
T-bills
13, 26, 52 weeks

Note: Terminology often differs across countries. e.g. T-notes in Australia, correspond to T-bills in the U.S
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 of whether or not it has made profits Interest payments have to be made before any payments can be made to equity shareholders
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 the claims of the bondholders will be settled. Only if something were to remain will the equity shareholders be entitled to stake a claim.
Negotiable vs. Non-negotiable

Can be freely traded Negotiable debt instruments 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
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Leverage
What is leverage?
Ability to magnify returns on investment by using borrowed money to partly fund the acquisition of the asset
Leverage is a double-edged sword

Positive returns get magnified So do negative returns
Leverage (Cont)
Take two companies A and B
A has a paid up capital of Rs 100,000 with no debt B has a paid up capital of Rs 50,000 with a debt of 50,000 carrying an annual interest of 10%.
We will take two cases

The first where the companies make an operating profit of Rs 25,000 And the second where they make an operating loss of Rs 25,000. To keep matters simple assume no taxes.
Leverage (Cont)
Leverage (Cont)
Company A is unlevered whereas company B is levered. Leverage is obviously a double edged sword.
In a booming market, a 25% return gets magnified to 40% But in a falling market a -25% return gets translated to a loss of -60%.
Balance Sheet
Assets
FUNDS
Liabilities
CLAIMS or DEBT or borrowed capital or EQUITY or owners capital
Total Assets = Total Liabilities

Balance Sheet
Assets
Plant & Machinery $ 100 MM Bank Deposit $ 100 MM
Liabilities
Share Capital $ 100 MM Bonds $ 100 MM
Total Assets
$ 200 MM
Total Liabilities $ 200 MM

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Preferred shares
Debt
Preferred shares
Equity
Promise a fixed rate of return In the event of liquidation, preferred shareholders get priority over equity shareholders
If firm is unable to pay as promised then shareholders cannot seek legal recourse 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
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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
Example of a Tax Shield

Consider two companies
Pre-tax profit Company A Company B Tax rate $100,000 0 interest liability $20,000 interest expense
30%
Example (Cont)
Company A PBIT Interest PBT Tax @ 30% PAT 100,000 0 100,000 30,000 70,000
Company B 100,000 20,000 80,000 24,000 56,000

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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)
Derivatives
Derivatives
These are essentially contracts which are based on, or the demand for which is derived from, the demand for an underlying asset.
Foreign currency Stock market indices
Bonds
Stocks Derivative contracts
Physical assets
Classes of derivative securities
Forward contracts
Futures contracts
Options contracts
Swaps
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 PRESENT
No money changes hands
delivery of asset pre specified time period FUTURE

Goods are delivered and money is paid
Example
price fixed at outset PRESENT

Mitoken agrees to buy 100,000 USD from ICICI Bank 90 days hence at INR 40.50 per USD. No money/assets change hands
delivery of asset pre specified time period FUTURE

After 90 days
Example (Cont)
The contract is negotiated individually between Mitoken and ICICI Such contracts are called OTC (Over-the-Counter) or customized contracts No money changes hand at the outset The actual transaction will take place only after 90 days But the terms are set at the start Both the parties have an obligation to perform ICICI Bank is obligated to deliver the dollars after 90 days Mitoken is obligated to accept the dollars and pay the equivalent in INR
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
Options Contracts
Call Option
Gives the buyer the right To buy an underlying asset On or before a pre specified date At a pre specified price
Put Option
Gives the buyer the right To sell an underlying asset On or before a pre specified date
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At a pre specified price
Forward/Futures contract
Options
Call options give the holder Futures/forward contracts impose an obligation to buy the right to buy the the underlying asset, on the underlying asset buyer of the contract
Obligation has to be fulfilled
Rights need be exercised only if such action is beneficial

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Call option
If the holder of a call option decides to exercise his right to buy, the seller of the option has an obligation to deliver the underlying asset
Put option
If a put holder were to exercise his right, the seller of the put has an obligation to buy the asset
Buyers 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
Example of a Call Option

Kevin has bought a call option from Kathy Gives him the right to buy 100 shares of IBM at $75 per share after 3 months Kathy will not give this right for free
Assume that Kevin pays $6.50 per share or $650 in all to acquire this right This amount has to be paid at the outset and is called the Option Price or Premium.
Example of a Call Option (Cont)

Assume that the price of IBM after 3 months is $ 80
Kevin will most certainly exercise his option and ask Kathy to deliver the shares This price of $ 80 per share is called the Strike Price or Exercise Price Kathy cannot refuse since she has an obligation to perform
What if the share price after 3 months were to be $ 70
Kevin will forget the option and buy the share in the market at $ 70 each
He is in a position to do so since an option is a right and not an obligation
In summary
Instrument Nature of Buyers Commitment Obligation to acquire the underlying asset Right to acquire the underlying asset Right to sell the underlying asset Nature of Sellers Commitment Obligation to sell the underlying asset Contingent obligation to deliver the underlying asset Contingent obligation to take delivery of the underlying asset.
Forward/futures contract Call Options
Put Options
Swaps
These are contractual arrangements between two parties to exchange specified cash flows at pre-specified points in time
Swaps
Interest rate swaps Notional principal
Currency swaps Principal denominated in two different currencies
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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 + a spread
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.
Diagrammatic Representation Borrower

Fixed rate
Bank A
Pay Fixed Receive T-bond Rate
Bank B
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
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
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 countrys 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.
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.

Most transfers are done electronically from one bank account to another.
Mortgage
A mortgage is a loan backed by real estate as collateral
Periodic payments
Mortgagor
borrower
Mortgagee
lender Can take over property
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Mortgage (Cont)
If the mortgagor defaults
The lender can foreclose the mortgage
What is foreclosure?
Takeover and sell the property to recover the dues
Mortgage (Cont)
A mortgage is an illiquid asset To rotate their capital
Lenders will pool mortgage loans Issue debt backed by the underlying pool Such securities are called MBS The process is called SECURITIZATION
Hybrid Securities
Convertible Bonds
Is a debt security Can be converted into equity shares
Warrants
Right given to the investor to subscribe to equity at a pre-determined price These are attached to a debt security They can be detached and traded in the secondary market
An investors concerns
Returns
Riskiness
Time pattern
Liquidity
Returns
Returns
Cash dividends Capital gains/losses
Riskiness
Time pattern
Liquidity
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 < cost pCapital 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
Risk
Returns
May not pay dividends Capital appreciation may be less/losses Firm may go into bankruptcy
Riskiness
Time pattern
Liquidity
Time pattern
Returns
Riskiness
Time pattern
Cash flows from bonds are predictable Cash flows from dividends can be volatile
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Liquidity
A rational investor
Returns
H I G H
L O W
Riskiness
Time pattern
Liquidity
Types of Rational Investors

Young investor Are more likely to prefer equities. May be content with the possibilities of substantial capital gains They may not require regular cash flows immediately More inclined towards risk Retired investor Usually prefer to invest in bonds. For them, the key issue is the availability of predictable periodic cash flows from the asset The key issue is the availability of predictable periodic cash flows from the asset Risk averse
Would of course demand Would be content with lower adequate compensation by returns way of higher expected Copyright Tarheel Consultancy Services returns
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Classification of Markets
Markets
Primary vs. Secondary
Direct vs. Indirect
Money vs. Capital

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Primary vs. Secondary Markets

PRIMARY MARKETS Company offers new financial instruments to the investing public. The very first issue of shares by a company is called an Initial Public Offering or IPO Companies issue shares and bonds SECONDARY MARKETS Once an asset has been bought by an investor from the company, subsequent transactions in the instrument take place in the secondary market Secondary markets merely represent the transfer of ownership of an asset from one investor to another
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Primary markets therefore enable borrowers to raise funds

Primary vs. Secondary Markets

PRIMARY MARKETS TCS is issuing shares for the first time to the public at Rs 850 per share Ravi applies for 1000 shares and is allotted 200 shares at a price of Rs 850 SECONDARY MARKETS ---
Six months later Ravi sells these shares on the National Stock Exchange for Rs 1250 per share
Are Primary Markets Alone Sufficient?

In order to facilitate savings and investment in the economy we need both primary as well as secondary markets
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!

In real life
We like assets which can be easily liquidated or converted into cash.
Liquidity needs can never be perfectly anticipated
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.
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.
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.
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.
Intermediaries
In either case market intermediaries are involved who facilitate a process of `matchmaking.
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 and quantity
Price Compatibility
Every trader seeks to trade at a `good price. What is a good price?
Buyers seek 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.
Quantity Compatibility
The quantity being offered should match the quantity being demanded.
Often a large sell order may require more than one buyer before getting fully executed. The same is true for large buy orders.
Market Intermediaries
Brokers
Market Intermediary Investment Bankers
Dealers
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
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.
Dealers
Client seeking to sell:
Dealer will buy the asset

Bid price
Sell later at higher price

Client seeking to buy:
Dealer will sell the asset

Ask / Offer
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Replenish inventory later at lower price
Dealers
Sell@Ask - Buy@Bid = Profit = Spread
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.
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.
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
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.
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.
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.
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.
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.
These are known as Greenshoe options.
Underwriting (Cont)
The underwriting fee compensates the investment bank for the sales effort as well as for the insurance Since a best efforts offer does not involve insurance the corresponding fees 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.
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.
Glass-Steagall (Cont)
The Act thereby segregated Investment Banking & Brokerage Operations from Commercial Banking. JP Morgan existed prior to the enactment of the Act After the Act was passed
A splinter group broke off to form Morgan Stanley an I Bank JPM continued as a commercial bank
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.
Bloombergs Top 20 Investment Banks

Citigroup Goldman Sachs Morgan Stanley JP Morgan Chase Merrill Lynch UBS Credit Suisse Deutsche Bank Lehman Brothers Bank of America ABN AMRO Bank Nomura Securities RBC Capital Markets HSBC Rothschild Daiwa Securities Lazard Wachovia Bear Stearns BNP Paribas
Indirect Markets
LENDERS LENDER
individual
BORROWER
Corporate borrower
family
Commercial bank Non corporate borrowers
Financial claims
Financial claims
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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
In. Market Intermediaries

Insurance cos
I. Market Intermediary Pension funds Mutual funds
Indirect Markets (Cont)

The depositors have no claim on the ultimate borrowers in this case. How does the bank make money?
By raising deposits at a rate that is lower than the interest rate charged by it on loans made to borrowers.
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
Indirect Markets
LENDERS LENDER
individual
BORROWER
Corporate borrower
family
Commonwealth Bank 4% pa
5.5% pa Telstra etc.
Financial claims Financial claims

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Illustration (Cont)
Assume that Telstra can directly issue bonds to the public, with a coupon rate of 4.75%.
Investors deposit Telstra Will save 0.75% as compared to borrowing from the bank
Banks margin of 1.5% has been shared by the company & investors
get 0.75% extra as compared to the bank
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
Denomination problem
E.g. A firm issues bonds with a face value of $100,000 small investors will be unable to subscribe.
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
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 printing costs Share application printing costs Legal fees Fees paid to advisors
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.
The Role of Intermediaries (Cont)

Financial institutions also facilitate risk diversification.
Diversification means that `dont 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. 167
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
Illustration
A business operation costs $ 1000 to mount The cost per unit is $1 If 1000 units are produced
Total cost = $ 2000 Per unit cost = $2
If 10000 units are produced

Total cost = 11000 Per unit cost = 1.10
Money Mkts. vs. Capital Mkts.

Money Markets
Time to maturity at the time of issue is one year or less Money market instruments by definition have to be debt instruments Money markets are used to adjust temporary liquidity imbalances. In practice, for any company, inflows and outflows at any point in time will rarely match
Capital Markets
Markets for medium to long term instruments Capital market securities include both long and medium term debt as well as equities Capital markets channelize funds from those who wish to save to those who seek to make long term productive investments
Money markets help firms to Capital markets are where borrow short term and also to companies source funds for their deploy surplus funds on a short long term investment needs 170 term basis 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
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
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
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
Historically
Open-Outcry: Historically trading on exchanges has taken place on trading rings / floors The BSE used to have this 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
Today
These days most exchanges are electronic communications networks and most traders no longer interact face to face
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. 175
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
There are approximately 2,800 stocks listed on the NYSE The market capitalization of NYSE listed companies is approximately 25 trillion dollars
Listing vs. Registration

What is Listing?
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 Registration?
This is a process required under the Securities and Exchange Act for most publicly held corporations.
Listing and Registration

Listing
There is no legal requirement that a company should get its shares listed on an exchange
Registration
Registration is mandatory and requires the submission of 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 178 Practices (GAAP)
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
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 NASDAQ
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
The Third Market

Market in stocks that are listed on an organized exchange
But are traded outside the exchange By brokers representing institutional investors
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 183 an offsetting position
The Fourth Market (cont)

Example
A mutual fund and a pension fund enter into a large block trade with each other
Both parties avoid
Brokerage Exchange transaction fees
International Stock Exchanges

Over the past two decades exchanges have mushroomed across the globe
Happened due to the increasing acceptance of the 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

International Exchanges
Successful exchange development requires
Strong property rights Strong contract laws and securities regulation laws Successful privatization programs Regulatory authorities with teeth
International Exchanges (Cont)

EXCHANGE NASDAQ Toronto NYSE Euronext Australian Securities Exchange BSE Hong Kong Korea NSE MARKET VALUE (Trillions of USD) 4.390 2.290 20.700 1.450 1.610 2.970 1.260 1.460
SHARE TURNOVER (Trillions of USD) 12.400 1.360 28.700 1.000 0.263 1.700 1.660 0.564
187
International Exchanges (Cont)

EXCHANGE Shanghai Tokyo Frankfurt London Swiss Sao Paulo Johannesburg MARKET VALUE (Trillions of USD) 3.020 4.630 2.120 4.210 1.330 1.400 0.940
SHARE TURNOVER (Trillions of USD) 3.560 5.450 3.640 9.140 1.580 0.476 0.349
188
Bond Markets
The number of different corporate and municipal bond issues far exceeds the number of available stocks
Bond markets are not very liquid.
In practice many bonds never trade after issue, because investors who buy them, choose to hold them till maturity.
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 occurs on the NYSE and the AMEX bond markets
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.
Actors or Players
Traders in the market can be divided into two categories.
Those who trade on their own account Proprietary traders trade on their own account Those that arrange trades for others 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 192 futures markets).
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
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
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
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 traders who seek to buy the services offered by the exchange
Sell side traders who offer the services of the exchange
traders are traders are those in search those who supply liquidity of liquidity traders on both sides regularly buy as well as sell securities 196
Buy side Refers to the portion of the securities business in which primarily institutional orders originate
Funds (mutual and pension) Firms Governments Insurance Companies Charitable and Legal Trusts
Sell side Consists of brokers and dealers who help buy side traders to trade at their convenience
This is selling liquidity
Market makers Specialists Floor Traders Locals Day Traders Scalpers Copyright Tarheel Consultancy Services
197
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
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
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
Definitions (Cont)
Floor Trader
Member of the exchange who trades on the floor for his or her own account a.k.a
Registered competitive traders Individual liquidity providers Locals
Note: Not to be confused with Floor Brokers
Clearing
After a trade has been matched by a trading system
Post trade processes need to commence
Clearing
The term refers to all post-trade processes other than final settlement
Settlement is the final step

Payment of cash to the seller Transfer of ownership to the buyer
Clearing (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 (Dont Knows) In the futures markets they are called Out Trades
Settlement Cycles
Normal-way settlement in the U.S occurs 3 business days after the day of trade for equities.
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.
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 and Clearing Corporation (DTCC), which holds nearly 36 trillion dollars in assets
Depositories (Comparisons with a Bank)

Commercial Bank Depository
1. Holds funds in an account 1. Holds securities in an account 2. Enables fund transfers between accounts 3. Facilitates transfers without having to handle money 4. Facilitates safekeeping of money 2. Enables transfers of securities between accounts 3. Facilitates transfers without having to handle securities 4. Facilitates safekeeping of securities
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.
Custodians (Cont)
Global custodians hold assets in multiple locations
Use local branches or other local custodians
What is the advantage?

All settlement instructions need to be sent to a single destination
Depositories & Custodians

They facilitate the settlement process by quickly transferring cash and securities to settlement agents upon receiving instructions from the traders.
Arbitrage
What is arbitrage?
Arbitrage may be described as the existence of the potential to make riskless profits by transacting in multiple markets.
IBM shares
NYSE $180 per share LSE 100 per share Exchange rate 2 $/
Borrow $18,000. Buy 100 shares on NYSE

$20,000
Sell on LSE for 10,000

Transfer back to NY
Profit = $2000
This transaction is costless and risk-less in a perfect setting Copyright Tarheel Consultancy Services
211
These opportunities cannot persist for long

IBM shares
NYSE $180 per share 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 is restored Copyright Tarheel Consultancy Services
212
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.
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.
IBM shares
NYSE $180.75 / $181.25 LSE 100.25 / 100.5 Exchange rate 2.05/2.15 $/
Borrow $18,125 Buy 100 shares on NYSE

$20,551.25

Transfer back to NY
Profit = $2426.25
215
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?
IBM shares
NYSE $180.75 / $181.25 LSE 100.25 / 100.5 Exchange rate 2.05/2.15 $/
Borrow $18,135 Buy 100 shares on NYSE

9995 x 2.05 = $20,489.75

Transfer back to NY
Profit = $2354.75
217
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
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.
Why Eurocurrency Markets?

Why should a bank outside the U.S accept deposits denominated in U.S.D.?
1. After World War II, the U.S. dollar became the preferred currency for global trade. Everyone wished to hold dollar balances. 2. 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 3. European banks began to realize that such funds could be profitably lent out, and consequently began to accept such deposits. 220
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.
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?
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.

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
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
Reserves
Statutory Liquidity Ratio (SLR): 25% of the deposit has to be maintained in the form of approved government securities
Cash Reserve Ratio (CRR): 8% of the deposit has to be maintained as cash with the RBI
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.
Example - Reserves
Due to high reserve requirements American banks could not offer attractive rates on deposits.
Matters were made 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
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
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
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
Floating Rate Loans

History
Loans have been made on the basis of a fixed rate
Today
The growth of the Eurocurrency market has lead to loans based on floating rates of interest The interest rates on such loans are not constant, but are linked to a benchmark. Consequently they vary with changes in the level of the benchmark. 232
The interest rate remains fixed for the tenure of the loan
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
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
Basis Point
What is a basis point?
A basis point is one hundredth of one percent 100 basis points = 1 percentage point
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
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
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: NOT COMMON
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

239
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
Eurobonds - Illustration
Sony is issuing bonds in Japan:
Issuer = Japanese company Principal = $10 billion Currency of issue = USD Currency of Japan = Yen
IBM is issuing bonds in Japan:

Issuer = American company Principal = $10 billion Currency of issue = USD Currency of Japan = Yen
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
Foreign bonds - Illustration

Not a Foreign Bond Foreign Bond
Sony is issuing bonds in Japan:

Issuer = Japanese company Principal = 100 billion Currency of issue = Yen Currency of Japan = Yen
IBM is issuing bonds in Japan:

Issuer = American company Principal = 100 billion Currency of issue = Yen Currency of Japan = Yen
243
Foreign Bonds
Foreign bonds have nicknames
U.S. Japan U.K. Yankee bonds Samurai bonds Bulldog bonds Kangaroo bonds
Australia
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
E.g. to issue US dollar bonds in Japan permission is not required from U.S. authorities
2. 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
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. In practice this has facilitated tax evasion and tax avoidance
4. Interest paid on such bonds is not subject to withholding taxes a.k.a. TDS in India
History of Eurobonds
Due to Regulation Q, U.S financial institutions could not offer high rates of interest Foreign companies were issuing Yankee bonds with relatively attractive rates of interest
Investors were flocking to these Yankee bonds
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
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.
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
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.
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.
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.
Universal Banking An Indian Illustration

Take the case of ICICI Bank
It is a traditional commercial bank
Accepts deposits Makes loans
Has an AMC that manages mutual funds

Collaboration with Prudential PLC
ICICI Prudential is into life insurance ICICI Lombard is into general insurance ICICI Home Finance makes real estate loans
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
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
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.
GDRs and ADRs

Foreign equity is traded on international markets in the form of Depository Receipts. Global Depository Receipts (GDRs)
Depository Receipts (DRs)
American Depository Receipts (ADRs)

258
What is an ADR?
A special share of foreign equity priced in USD
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 issuers country
An ADR issue process

India India
Domestic shares
Wipro
Custodial Bank
SBI
Depository Bank
USA
JP Morgan
Copyright of New York Bank Tarheel Consultancy Services
ADRs
USA
260
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
Illustration
India
USA
Domestic shares
Rs. 30 / share
ADRs
60c /share
USA
1 ADRs = 10 domestic shares

$6 /share
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 depository will in turn have the and ADRs acquired in lieu
equivalent number of shares sold in the home market
Less attractive from the standpoint of an American investor Has potential to reduce liquidity and the floating stock of DRs
Required to ensure that there are no arbitrage opportunities between the U.S and the home market
263
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
Overvalued hence shortsell
Domestic shares
Buy in India Convert to ADRs
Arbitrageur Infosys ADR overvalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares

$210 / ADR Shortsell 1 ADR(+$210) Convert Profit = $10
Domestic shares
Rs.1000 /share Acquire 10 shares (-Rs.10,000) $200
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
Undervalued hence buy
Domestic shares
Sell in India
266
Convert to domestic Services Copyright Tarheel Consultancy shares
Arbitrageur Infosys ADR undervalued
USA
Exch rate Rs. 50/dollar
India
1 ADR = 10 domestic shares

$190 / ADR Buy 1 ADR(-$190) Convert Profit = $10
Domestic shares
Rs.1000 /share Sell 10 shares (+Rs.10,000) $200
ADRs - History
The first ADR was created by J.P. Morgan in 1927.
From the standpoints of clearing and settlement: ADR is like a domestic U.S security Traded on NYSE, AMEX, Nasdaq, and OTC markets
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.
Levels of ADRs
Levels of ADRs
Unsponsored ADRs
Sponsored Level-1 ADRs
Unsponsored Sponsored ADRs Level-I 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
Sponsored Level-II ADRs
Sponsored Level-III ADRs
require financial require even statements more paperwork conforming to U.S. GAAP, and disclosure in accordance with SEC regulations allow issuance and sale of new shares to raise equity capital in the U.S.
271
issues are not initiated by the parent foreign company
can be traded can be traded on OTC mkts in on U.S. the U.S. and on exchanges some exchanges outside the U.S
Benefits to Issuers
Companys 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
Benefits to Holders
Get access to assets which are quoted in USD and trade like any U.S. security Get dividends in USD
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.
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
IBFs - History
History
To allow U.S. banks to compete effectively with offshore banks (Eurobanks) without having to set up an office offshore
Today
Over 75% of the deposits are with IBFs located in New York State
California and Illinois are the other states with significant IBF activities
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
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.
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.
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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

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Tarheel Consultancy Services

Corporate Training and Consulting

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Role of an Economic System

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Role of an Economic System (Cont)

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Role of an Economic System (Cont)

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Economic Decisions (Cont)

Distribution of the output

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Economic Decisions (Cont)

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Role of an Economic System (Cont)

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Role of an Economic System (Cont)

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Role of an Economic System (Cont)

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Role of an Economic System (Cont)

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Command Economies (Cont)

Role of the planner

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Command Economies (Cont)

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Command Economies (Cont)

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Market Economies (Cont)

Optimal decision is the one that

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Market Economies (Cont)

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Market Economies (Cont)

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Market Economies (Cont)

If price is too high

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Market Economies (Cont)

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Buyer & Seller

Money & Markets

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Prior to advent of MONEY

Consume all the goods you have

Could not put away goods for later use

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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

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Distribution of the output

Role of the planner

Optimal decision is the one that

If price is too high

Consider a 10 good barter economy

However if we had a unit of currency

The Capital Account

What are reserve assets?

Why is liquidity important?

Attributes of liquid assets

Money is the most perishable of assets

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

Shareholders are given voting rights.

What does this mean?