Capital markets

 The market where investment instruments like bonds,

equities and mortgages are traded is known as the capital
market.

 The primal role of this market is to make investment from

investors who have surplus funds to the ones who are
running a deficit.
 The capital market offers both long term and overnight
funds.

 The different types of financial instruments that are

traded in the capital markets are:
> Equity instruments
> Credit market instruments,
> Insurance instruments,
> Foreign exchange instruments,
> Hybrid instruments and
> Derivative instruments.
Long Term Borrowings
 Introduction
 Phenomenal changes have swept financial markets
around the world during the 1980's and the 1990s

 Financial markets everywhere serve to facilitate

transfer of resources from surplus units (savers) to
deficit units (borrowers), the former attempting to
maximise the return on their savings while the latter
looking to minimise their borrowing costs

 An efficient financial market thus achieves an optimal

allocation of surplus funds between alternative uses
and healthy financial markets also offer the savers a
wide range of instruments enabling them to diversify
their portfolios
 Globalisation of financial markets during the
eighties has been driven by two underlying forces

 Growing (and continually shifting) imbalance

between savings and investment within individual
countries
 Increasing preference on the part of investors for
international diversification of their asset portfolios
 Liberalisation and integration of financial markets

 The markets themselves have proved to be highly

innovative, responding rapidly to changing investor
preferences and increasingly complex needs of the
borrowers by designing new instruments and
highly flexible risk management products

 The combined result of these processes has been

the emergence of a vast, seamless global financial
market transcending national boundaries
 It is by no means true that controls and government
intervention have entirely disappeared

 For developing countries, as far as debt finance is

concerned, external bonds and syndicated credits
are the two main sources of funds
Legal Framework in India for Foreign Investment

• In India the Legal framework for foreign investment in India is

segregated primarily in two parts; one governs the investment in
capital and the other borrowings.

• The set of rules that govern the investment in capital is commonly

called Foreign Direct Investment (FDI) Regulations. Whereas the
set of rules that governs foreign investment in form of borrowings is
called External Commercial Borrowing (ECB) Regulations.

• Let us first have a closer look to what exactly falls under which set
of rules. Foreign Direct Investment as the name suggests is the
investment made towards core capital of an organization viz.
investment in equity shares, convertible preference share and
convertible debentures.
•
•Till late there was ambiguity about the partially convertible
preference shares and debentures being considered as part
of Foreign Direct Investment.
• However in June 2007 the Reserve Bank of India has
clarified as follows :
• Only instruments which are fully and mandatorily
convertible into equity within a specified time would be
reckoned as part of equity under the FDI Policy and will be
eligible to be issued to person’s resident outside India under
the Foreign Direct Investment Scheme.
• Thus it is now crystal clear that the investment in non-
convertible or partially convertible preference shares and
debentures or any instrument with no definite period for
conversion in equity will come under the purview of ECB
Guidelines.
• Moreover any investment as commercial loans [in the
form of bank loans, buyers’ credit, suppliers’ credit,
securitized instruments (e.g. floating rate notes and fixed
rate bonds)] availed from non-resident lenders with
minimum average maturity of 3 years will also come under
the purview of ECB Guidelines.
The Major Funding Avenues
 The funding avenues potentially open to a
borrower in the global capital markets can be
categorised as follows
 Bonds : Foreign Bonds and Eurobonds
 Straight Bonds
 Floating Rate Notes (FRNs)
 Zero-coupon and deep discount bonds
 Bonds with a variety of option features
embedded in them
The Major Funding Avenues
 Syndicated Credits
 These are bank loans, usually at floating rate of
interest, arranged by one or more lead managers
(banks) with a number of other banks participating
in the loan
 Medium Term Notes (MTNs)
 Initially conceived as instruments to fill the maturity
gap between short-term money market instruments
like commercial paper and long-term instruments
like bonds, these subsequently evolved into very
flexible borrowing instruments
The Major Funding Avenues
 Committed Underwritten Facilities
 The basic structure under this is the Note Issuance
Facility (NIF), these instruments were popular for a
while before introduction of risk-based capital
adequacy norms rendered them unattractive for
banks

 Money Market Instruments

 These are short-term borrowing instruments and
include commercial paper, certificates of deposit
and bankers' acceptances among others
The Major Bond Market Segments
 Eurobonds : Unregistered, bearer
Foreign Bonds : Non-resident issues in a country’s
domestic capital market
 Yankee Bonds : Public issues in US. Strict regulation
 Private placements : Less strict regulation
 Samurai Bonds : Public Issues in Japan
 Shibosai Bonds : Shogun Bonds and Geisha Bonds
Private placements in Japan
Swiss and German Bonds : Public Issues and Private
placements
 Bulldog Bond : UK Public Issues
 Rembrandt Bonds : Holland Public Issues
 Syndicated Credits

 A traditional Euro syndicated loan is usually a

floating rate loan with fixed maturity, a fixed
drawdown period and a specified repayment
schedule
 Lead managers, Syndicate members and Agent bank
 A typical Euro credit would have maturity between
five and 10 years, amortisation in semi-annual
instalments, and interest rate reset every three or six
months with reference to LIBOR
 Club Loans : Private deals, unpublicised
 Revolving Credit
Syndicated Credits

 Standby facility

 The cost of a loan consists of interest and a number

of fees - management fees, participation fees, agency
fees and underwriting fees when the loan is
underwritten by a bank of a group of banks

 Apart from the Euromarkets, syndicated credits can

be arranged in some of the national capital markets
such as Japan and UK.
Other Securitised Funding Avenues
 MTNS and EMTNs
 Originally evolved as a bridge between short-term
money market products and long term bonds

 The main advantage of borrowing via an MTN or

EMTN programme is its flexibility and much less
onerous formalities of documentation compared to a
bond issue; timing flexibility, multicurrency facility

 The market is accessible only to issuers with good

credit rating
The International Financing Decision

 The issue of the optimal capital structure and

subsequently the optimal mix of funding
instruments is one of the key strategic decisions for
a corporation
 The actual implementation of the selected funding
programme involves several other considerations
such as
satisfying all the regulatory requirements,
choosing the right timing and
pricing of the issue,
effective marketing of the issue and so forth
The International Financing Decision
The International Financing Decision

 The critical dimensions of this decision for a firm to

chose funding avenues

 Interest rate basis : Mix of fixed rate and floating rate debt
 Maturity : The appropriate maturity composition of debt;
long term or short-term rolled over
 Currency composition of debt
 Which market segments should be tapped
 Take advantage of any market imperfections
 Take advantage of subsidized financing opportunities
 All-in cost, currency risk, interest rate risk
The International Financing Decision
 These dimensions interact to determine the overall
character of the firm's debt portfolio

 The overall guiding principles in choosing a debt

portfolio
 “The nature of financing should normally be driven by the
nature of the business, in such a way as to make debt-service
payments match the character and timing of operating
earnings. Because this reduces the probability of financial
distress, it allows the firm to have greater leverage and therefore
a greater tax shield. Deviation from this principle should occur
only in the presence of privileged information or some other
market imperfection. Market imperfections that provide
cheaper financing exist in practice in a wide range of
circumstances.” - Giddy
The International Financing Decision

 Overriding these considerations are issues of

regulation and market access

 In viewing the risks associated with funding

activity, a portfolio approach needs to be adopted

 Currency and interest rate exposures arising out of

funding decisions should not be viewed in isolation
but as total risk of asset-liability portfolio and
exposures arising out of regular operations.
The International Financing Decision
 In comparing funding options the following
parameters have to be examined under alternative
scenarios

 The all-in cost of a particular funding instrument –

under alternative simulations of paths of interest
rates and exchange rates
 Interest rate and currency exposure arising from
using a particular financing vehicle
 The International Financing Decision

 Consider a firm which is contemplating a fixed rate

foreign currency loan (or a fixed rate foreign
currency bond issue)

 The nominal rate of interest is I (expressed as a

fraction not percentage), the maturity is N years,
interest is paid annually and repayment is bullet
 The principal amount is A
The International Financing Decision
 The rate of exchange at time t is denoted St expressed
as units of home currency per unit of foreign
currency

 The real cost of this loan consists of three

components viz. the nominal interest, appreciation
of the foreign currency and domestic inflation is R =
I+ŝ-

 ŝ denotes proportionate change in the spot rate and

 is the domestic rate of inflation

 The variance of the real cost therefore is

Var(R) = Var(ŝ) + Var () - 2Cov (ŝ, )
The International Financing Decision

 To compare the variances of real costs, the

covariance term is important

 Between two currencies, if the variance of both is

nearly equal, the one which obeys PPP with the
home currency more closely will have a lower
variance of real cost of borrowing

 If the real cost risk is ignored, the choice of currency

should be based on a comparison of effective interest
rates which consist of the nominal interest rate I, and
the expected rate of appreciation of the foreign
currency Se
When the nominal interest rate itself is
not fixed - as with a floating rate loan -
an additional source of risk is
introduced viz. the variance of the
nominal interest rate and its
covariance's with the exchange rate and
domestic inflation rate.
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