MBA 2nd year

UNIT-4

BORROWING AND LENDING

 A process is known as lending when an entity or person gives away its

resources to another entity or person per predefined mutual terms. In
contrast, the process of receiving resources by an entity or person from
another entity or person with predefined mutually agreed upon terms is
known as borrowing.
 Both are part of single transactions with different purposes of parties
involved.
 Lending is the process of giving money to an entity/person. However,
borrowing is receiving money from an entity/person.
 In borrowing, resources are borrowed by a resource deficit entity from a
resource surplus entity. However, in lending, resources are lent to a resource
deficit entity by a resource surplus entity.
 The lending entity in the transaction receives interest against the
moneylender to the borrower. However, the borrowing entity pays interest to
lend a set-up against the borrowed money.
 Both are very critical to the economy of any country and operate with
different purposes/business models. Lending the entity’s purpose is to earn
interest on the money lent to borrowing entities. However, the borrowing
entities borrow money for their business expansion, or individuals borrow
money to meet their goals such as house construction, children’s education,
etc.
 Both are executed on commercial or non-commercial terms based on the
nature of the transaction. However, lending entities and borrowers who
dictate the terms of transactions have a relatively lesser say.
 Regulatory compliances for lending entities are much stricter than the
borrowing entities.

Floating-rate note

 A floating-rate note is a bond that has a variable interest rate, vs. a fixed-
rate note that has an interest rate that doesn't fluctuate.
  The interest rate is tied to a short-term benchmark rate, such as LIBOR or
the Fed funds rate, plus a quoted spread, or rate that holds steady.
 Many floating-rate notes have quarterly coupons, meaning that they pay
interest four times a year, but some pay monthly, semiannually, or annually.
 FRNs appeal to investors because they can benefit from higher interest rates
since the rate on the floater adjusts periodically to current market rates.

Floating Rate Notes (FRNs)

Floating-rate notes (FRNs) make up a significant component of the U.S.

investment-grade bond market. Compared with fixed-rate debt instruments,
floaters allow investors to benefit from a rise in interest rates since the rate on the
floater adjusts periodically to current market rates. Floaters are usually
benchmarked against short-term rates like the Fed funds rate, which is the rate the
Federal Reserve Bank sets for short-term borrowing between banks.

Fixed Rate

 A fixed, or pegged, rate is a rate the government (central bank) sets and
maintains as the official exchange rate. A set price will be determined
against a major world currency (usually the U.S. dollar, but also other major
currencies such as the euro, the yen, or a basket of currencies).

 In order to maintain the local exchange rate, the central bank buys and sells
its own currency on the foreign exchange market in return for the currency
to which it is pegged.

Floating Rate vs. Fixed Rate: An Overview

 All of the volume traded in the currency markets trades around an exchange
rate, the rate at which one currency can be exchanged for another. In other
words, it is the value of another country's currency compared to that of your
own.

 If you are traveling to another country, you need to "buy" the local
currency. Just like the price of any asset, the exchange rate is the price at
which you can buy that currency. If you are traveling to Egypt, for example,
and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this means
that for every U.S. dollar, you can buy five and a half Egyptian pounds.
  Theoretically, identical assets should sell at the same price in different
countries, because the exchange rate must maintain the inherent value of
one currency against the other.

 Fixed exchange rates mean that two currencies will always be exchanged at
the same price while floating exchange rates mean that the prices between
each currency can change depending on market factors; primarily supply
and demand.

 A floating exchange rate is determined by the private market through supply

and demand.

 A fixed, or pegged, rate is a rate the government (central bank) sets and
maintains as the official exchange rate.

 The reasons to peg a currency are linked to stability. Especially in today's

developing nations, a country may decide to peg its currency to create a
stable atmosphere for foreign investment.

Syndicated Loan

 A syndicated loan is a form of financing that is offered by a group

of lenders. Syndicated loans arise when a project requires too large a loan
for a single lender or when a project needs a specialized lender with
expertise in a specific asset class.

 Syndicating allows lenders to spread risk and take part in financial

opportunities that may be too large for their individual capital base. Lenders
are referred to as a syndicate, which works together to provide funds for a
single borrower. The borrower can be a corporation, a large project, or a
sovereign government. The loan can involve a fixed amount of funds,
a credit line, or a combination of the two.

 A syndicated loan is financing offered by a syndicate made up of a group of

lenders that work together to provide funds for a borrower.

 The borrower can be a corporation, a large project, or a sovereign

government.
  Syndicated loans involve a large sum, which allows the risk to be spread out
among several financial institutions to mitigate the risk in case the borrower
defaults.

What Is Euro credit

 Euro credit refers to a loan whose denominated currency is not the lending
bank's national currency. The concept is closely linked to that
of Eurocurrency, which is any currency held or traded outside its country of
issue. For example, a Eurodollar is a dollar deposit held or traded outside
the U.S., and conversely, a euro credit loan made by a U.S. bank would be
one that is not denominated in USD.

 The "euro-" prefix in the term arose because originally such currencies were
held, and loans made, in Europe, but that is no longer solely the case and a
Eurocurrency can now be held or a euro credit loan made anywhere in the
world that local banking regulations permit.

 Euro credit refers generally to a loan that is denominated in a currency

different from the lender's national money.
 The most common type of euro credit is the Eurodollar, dollar-denominated
deposits or loans held by non-U.S. banks.
 Euro credit refers not only to European banks, but also to any situation
where the lending currency differs from the home currency.

What is ADR
 ADR stands for American Depository Receipts, which are a type of
negotiable instrument that are basically stocks of foreign companies which
are traded in US stock markets.
 American Depository Receipts (ADR) is issued by a US Depository bank
and offer investors in the US to invest in foreign companies. ADRs are
traded on the US Stock exchange and are a great option for foreign
companies to attract investors from the US.
 ADRs are traded in New York Stock Exchange (NYSE) or NASDAQ, but
can also be sold over the counter. ADRs are priced in US Dollars.
Types of ADRs

 Sponsored ADR
 Non-sponsored ADR
Sponsored ADR:

In sponsored ADR, the foreign company that is looking to issue shares to the
public gets into an agreement with a US Depository bank for the purpose of
selling shares in the US capital market.

 The US depository bank carries the responsibility of sale, distribution of

shares to the public and also maintains record-keeping, dividend
distribution. ADRs that are sponsored are listed in US stock exchanges.
 US stock exchanges are regulated by the SEC (Securities and Exchange
Commission) which acts as a watchdog for all the necessary compliances
that should be maintained while trading in US stock exchanges and
instruments.

Non-sponsored ADR:

Non-sponsored ADR is created by brokers and dealers without the involvement

of the foreign company. These types of ADRs are sold over the counter and do
not require any registration with the SEC (Securities and Exchange
Commission).

Advantages of ADR

 An American investor can invest in any foreign company which increases

the possibility of generating higher returns.
 Foreign companies can get registered in the US Stock exchange and earn
more profit and capital.
 Companies can benefit from currency fluctuations.
 ADRs offer an easy option to invest in the US Market
 Pricing of ADRs in the US capital market is cheaper and hence, is an
attractive option for the investors.
Disadvantages of ADR
 ADR has the following disadvantages:
 Investors need to wait for a long time to generate good returns on ADR.
 It presents a risk of foreign exchange fluctuations
 A limited number of companies register via ADR; hence investors have
fewer choices for investment.

What Is a Global Depositary Receipt (GDR)?

A global depositary receipt (GDR) is a negotiable financial instrument issued by a

depositary bank. It represents shares in a foreign company and trades on the local
stock exchanges in investors' countries. GDRs make it possible for a company (the
issuer) to access investors in capital markets beyond the borders of its own
country.

GDRs are commonly used by issuers to raise capital from international investors
through private placement or public stock offerings. A global depositary receipt is
very similar to an American depositary receipt (ADR) except that an ADR only
lists shares of a foreign company in U.S. markets.

 A global depositary receipt is a tradable financial security.

 It is a certificate that represents shares in a foreign company and trades on

two or more global stock exchanges.

 GDRs typically trade on American stock exchanges as well as Eurozone or

Asian exchanges.
 GDRs and their dividends are priced in the local currency of the exchanges
where the GDRs are traded.
 GDRs represent an easy way for U.S. and international investors to own
foreign stocks.

GDR Characteristics

GDRs are exchange-traded securities that are not directly backed by any
underlying collateral (as shares of a company are backed by their assets). GDRs
instead represent ownership of shares in a foreign company, where those actual
shares are traded abroad.

 Conversion ratio: The conversion ratio is the number of shares of the

underlying company that are represented by each GDR. This ratio can vary
from one GDR to another, and it may be adjusted over time to reflect
changes in the underlying shares.
 Denomination: GDRs can be denominated in different currencies, such as
U.S. dollars, Euros, or pounds sterling. The currency used for a GDR may
impact its price and the risks associated with the investment, such as
currency risk, as the price of its shares overseas are priced in local currency.
 Sponsorship: GDRs are issued by depository banks, and the specific bank
that sponsors a GDR may vary from one GDR to another. Different banks
may have different reputations, financial strength, and other characteristics
that could impact the risks and potential returns of a GDR.
 Fees: GDRs may also vary in terms of the fees that are charged for issuing,
trading, or holding the GDRs. These fees can impact the overall cost and
potential returns of an investment in a GDR.

Advantages and Disadvantages of GDRs

 GDRs help international companies reach a broader, more diverse audience

of potential investors.
 They can potentially increase share liquidity.
 Companies can conduct an efficient and cost-effective private offering.
 Shares listed on major global exchanges can increase the status or
legitimacy of an otherwise unknown foreign company.
 For investors, GDRs provide the opportunity to diversify portfolios
internationally.
 GDRs are more convenient and less expensive than opening foreign
brokerage accounts and purchasing stocks in foreign markets.
 Investors don't have to pay cross-border custody or safekeeping charges.
 GDRs trade, clear, and settle according to the investor's domestic process
and procedures.
  U.S. holders of GDRs realize any dividends and capital gains in U.S.
dollars.

Disadvantages

 GDRs may have significant administrative fees.

 Dividend payments are net of currency conversion expenses and foreign
taxes.
 The depositary bank automatically withholds the amount necessary to
cover expenses and foreign taxes.
 U.S. investors may need to seek a credit from the Internal Revenue
Service (IRS) or a refund from the foreign government's taxing authority
to avoid double taxation on capital gains realized.
 GDRs have the potential to have low liquidity, making them difficult to
sell.
 In addition to liquidity risk, they can have currency risk and political
risk.
 This means that the value of GDR could fluctuate according to actual
events in the foreign county, such as recession, financial collapse, or
political upheaval.

Pros
 Easy to track and trade

 Denominated in local currency

 Regulated by local exchanges

 Offers international portfolio diversification

Cons

 More complex taxation

 Limited selection of companies offering GDRs

 Investors exposed indirectly to currency and geopolitical risk

  Potential lack of liquidity

Interest rate risk

Internal rate risk is the probability of a decline in the value of an asset resulting
from unexpected fluctuations in interest rates. Interest rate risk is mostly associated
with fixed-income assets (e.g., bonds) rather than with equity investments. The
interest rate is one of the primary drivers of a bond’s price.

Managing interest rate risk

Banks can manage IRR by either adjusting the composition of their balance sheet
or hedging with derivatives. One approach is to match the interest rate sensitivity
of assets and liabilities in specific reprising buckets. This is effective for mitigating
IRR when net interest income accounts for the bulk of profits.

Bond prices are worth watching from day to day as a useful indicator of the
direction of interest rates and, more generally, future economic activity. Not
incidentally, they're an important component of a well-managed and diversified
investment portfolio. Bond prices and bond yields are always at risk of fluctuating
in value, especially in periods of rising or falling interest rates. Let's discuss the
relationship between bond prices and yields.

 A bond's yield is the discount rate that links the bond's cash flows to its
current dollar price.
 A bond's coupon rate is the periodic distribution the holder receives.
 Although a bond's coupon rate is fixed, the price of a bond sold in
secondary markets can fluctuate.
 As the price of a bond increases or decreases, the true yield will change—
straying from the coupon rate to make the investment more or less enticing
to investors.
 All else equal, when a bond's price falls, its yield increases. When a bond's
price increases, its yield decreases.

Bond management strategies

The four principal strategies used to manage bond portfolios are: Passive, or "buy
and hold" Index matching or "quasi-passive" Immunization, or "quasi-
active" Dedicated and active. A number of options are available for structuring a
bond portfolio, and each strategy comes with its own risk and reward tradeoffs.

 Passive, or "buy and hold"

 Index matching, or "quasi-passive"
 Immunization, or "quasi-active"
 Dedicated and active

 Owning a bond portfolio can generate steady income, but bond prices are
sensitive to interest rate changes.
 An active approach requires staying ahead of interest rate moves.
 An immunization approach reduces the impact of interest rate changes on a
portfolio's value.

Passive Bond Management Strategy

 The passive buy-and-hold investor is looking to maximize the income-
generating properties of bonds. Buy and hold involves purchasing
individual bonds and holding them to maturity.
 To the passive investor, bonds are a safe, predictable source of income. The
cash flow can contribute immediately to the investor's income or can be
reinvested in other bonds or other assets.
 In a passive strategy, there are no assumptions made as to the direction of
future interest rates and any changes in the current value of the bond due to
shifts in the yield are not important. The bond may be originally purchased
at a premium or a discount while assuming that full par will be received
upon maturity.

Bond Laddering in Passive Investing

 Bond laddering is one of the most common forms of passive bond investing.
The investor divides the portfolio into equal parts, and then buys bonds that
mature on different dates. Each maturity date represents a "rung" on the
ladder, which is the investor's entire time horizon. As the bonds reach
 maturity, the proceeds are reinvested at the currently available rate. This
strategy reduces the impact of fluctuation in bond rates.

Indexing Bond Strategy

 Indexing is considered to be quasi-passive by design. The main objective of

indexing a bond portfolio is to provide a return and risk characteristic
closely tied to the targeted index.

 While this strategy carries some of the same characteristics of the passive
buy-and-hold, it has some flexibility. Just like tracking a specific stock
market index, a bond portfolio can be structured to mimic any published
bond index. One common index mimicked by portfolio managers is the
Bloomberg U.S. Aggregate Bond Index. Due to the size of this index, the
strategy would work well with a large portfolio due to the number of bonds
required to replicate the index.

 One also needs to consider the transaction costs associated with the original
investment and the periodic rebalancing of the portfolio to reflect changes
in the index.

Immunization Bond Strategy

 The immunization strategy has some of the characteristics of both active

and passive strategies. It seeks to match the duration of assets and liabilities
(such as discounted future cash flows required by the portfolio) to protect
against interest rate fluctuations. By definition, pure immunization implies
that a portfolio is invested for a defined return for a specific period of time
regardless of any outside influences, such as changes in interest rates.

 Similar to indexing, the immunization strategy potentially gives up the

upside potential of an active strategy for the assurance that the portfolio will
achieve the intended desired return. As in the buy-and-hold strategy, the
instruments best suited for this strategy are high-grade bonds with remote
possibilities of default.

Active Bond Strategy

 The goal of active management is maximizing total return. Along with the
enhanced opportunity for returns comes increased risk. Some examples of
active styles include interest rate anticipation, timing, valuation, spread
exploitation, and multiple interest rate scenarios. The basic premise of all
active strategies is that the investor is willing to make bets on the future
rather than settle for the potentially lower returns a passive strategy offers.