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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
Introduction
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
Introduction
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
Introduction
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
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 persons resident outside India under the Foreign Direct Investment Scheme.
Thus it is now crystal clear that the investment in nonconvertible 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, securitised 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.
Deficits and External Financing - Developing & Emerging Market Economies ( $ Bill.)
_________________________________________________ ITEM
BALANCE ON CURRENT ACCOUNT
2001
38
2002
84
2003
121
148
181
160
144
254
156
NET EXTERNAL BORROWING -33 (FROM OFFICIAL SOURCES) 33 (FROM PRIVATE SOURCES) -66
16 10 6
98 19 79
2007
1 Syndicated Credit
2008
1682 1304 316 2436
Facilities Borrowers from (i) Developed Countries (ii) Developing Countries 2 Debt Securities (Net Issues) Issuers from (i) Developed Countries (ii) Developing Countries 2a Money Market Instruments* 2b Bonds and Notes
2345 28 82 2355
Introduction
Indian entities began accessing external capital markets towards the end of seventies as gradually the amount of concessional assistance became inadequate to meet the increasing needs of the economy The Indian authorities adopted a selective approach and permitted only a few select banks, all India financial institutions, and large public and private sector companies to access the market
Price-Earnings Ratio (Per cent) 17.8 18.6 14.3 14.6 16.8 9.0
Till a few years ago, external commercial borrowings was the major source of nongovernmental external funding. By and large, India's borrowings have been by way of syndicated bank loans, buyers' credits and lines of credits We will obtain an overview of the major segments of the global debt markets in terms of funding avenues, general regulatory framework, accessibility and some procedural aspects Examine the analytics of the international financing decisions from the borrower's point of view and risk-return considerations from the investor's point of view
10343
863 11794 6789 92612 96886
10094
776 13559 6780 94327 98263
9899
622 16568 5923 97504 101132
9971
489 17154 5005 95744 98489
CHINA INDIA
18.4 21.1
----0.7 3.0
-0.3 ---0.5
S.KOREA 16.2
BRAZIL 15.0
MEXICO 12.3
1.5
1.5
-3.8
-3.4
0.9
-2.2
1.2
0.1
-0.5
-0.1
ALL COUNTRIES
279
307
170.1
DEVELOPED
DEVELOPING
ASIA-PACIFIC INDIA CHINA S.KOREA
241
34
9.9 8.5 3.6 -0.8
298
8.6
-0.1 2.4 2.2 0.9
169.9
-0.9
-0.8 -0.4 --0.9
2008
82
2009Q1
-71
COMMERCIAL PAPER
CORPORATE ISSUERS
15
-6.5
71
26.7 -31.7
-32
-8.6 -7.1
11.1
1.0 9.7
-38.9
-0.5 -37.3
FLOATING RATE
CORPORATE ISSUERS FINANCIAL INSTITUTIONS STRAIGHT FIXED RATE CORPORATE ISSUERS FINANCIAL INSTITUTIONS EQUITY RELATED CORPORATE ISSUERS FINANCIAL INSTITUTIONS
1129.8
23.6 1110.0 1612.4 253.3 1237.2 35.9 8.9 27.3
1206.3
---1215.3 1140.5 280.2 766.8 7.8 -0.4 8.3
103.1
-4.4 93.6 644.0 185.1 334.9 -6.7 -1.5 -5.1
A TRADITIONAL SYNDICATE
RISK OF A FOREIGN BOND FROM THE INVESTOR'S VIEWPOINT Recall that the sensitivity of the price of a coupon bearing instrument to changes in interest rate is measured by the duration of the security :
dP D=- P d(1+ r) (1 + r))
where P is the price of the bond and r is the yield. Thus duration is the (negative) of the elasticity of bond price with respect to the discount factor (1+r). A simple measure[of duration known as "Macaulay Duration" (MD) is given by
t = T CF t t (1 + r ) t t = 1 MD = t = T CF t t t = 1 (1 + r )
Now consider a foreign bond. Its price in its currency of denomination (the "foreign currency") is denoted P. To an investor with a different "home" currency, its value in that currency is V = PS where S is the spot rate in units of home currency per unit of foreign currency. Take logs and differentiate to yield dlnV = dlnP + dlnS dlnP = dP/P = -D[dr/(1+r)]
But
where a = D/(1+r).
Thus risk of a foreign bond from the investor's viewpoint depends not only upon the duration of the security but also upon how volatile interest rates are in the country of the currency of denomination of the bond, the volatility of the spot rate and the covariance of the two.
The contribution of these separate sources of risk varies depending upon the domicile of the investor and the country of issue and currency of the bond.
Then the after-tax return would be 2.4% on the dollar asset [= (1-0.4) 4%] and 2.8% on the yen denominated asset [= (1-0.4) 2% + (1-0.2) 2%]. Investors might lower the nominal rate on Yen loans.
Syndicated Credits
A traditional Eurosyndicated 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 Eurocredit would have maturity between five and 10 years, amortisation in semiannual 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.
Underwritten Facilities
NIF and Related Facilities
Highly rated borrowers decided to short circuit the banks and raise financing directly from investors by issuing their own paper A Note Issue Facility (NIF) is a medium-term legally binding commitment under which a borrower can issue short-term paper in its own name, but where underwriting banks are committed either to purchase any notes which the borrower is unable to sell, or to provide standing credit
Project Finance
The central idea in project financing is to arrange a financing package which will permit the transfer or sharing of various risks among several parties including project promoters with a no recourse or limited recourse feature The lenders evaluate the project as an independent entity and have claims on the cash flows generated by the project for their interest payments and principal repayments without recourse to any other assets owned by the project promoters. Lenders would like to maximise the chances of project success. Involve project contractors as an equity partner, take-or pay guarantees from major customers of project output, guarantees from suppliers, counter-guarantees etc.
Project Finance
The lenders may require guarantees In some circumstances, third party guarantees can be arranged The sources of equity and debt finance for projects have been numerous An innovation in project finance is the BOT device which stands for Build, Own and Transfer (some times also called BOOT - Build, Own, Operate and Transfer)
Concept of co-finance Joint financing by private lenders and multilateral agencies like World Bank A variety of funding techniques, risk sharing strategies and risk management tools such as swaps and options are packaged together for a large project The nature of all these markets and instruments is very dynamic In the Indian context, the government's regulatory stance on accessing these funding avenues needs to be kept in mind
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
A bond issue with an embedded currency option from a class of instruments called Indexed Currency Option Notes (ICONS).
In 1985 Bankers Trust (BT) lead managed for Long Term Credit Bank (LTCB) of Japan an issue of $120 million Eurobonds with a coupon of 11.5% p.a. and maturity of 10 years. The redemption amount R at maturity will depend upon the value at that time of the spot /$ exchange rate S as follows : If S 169, R = $120 million If S < 169 R = $(120000000){1 [(169-S)/S]} Effectively, the investors in the bond have granted LTCB a put option on dollars against yen at a strike price of 169.00/$ for an amount of $120 million.
BT purchased the put option from LTCB in return for a reduction in LTCB's borrowing cost. This was achieved as follows. It arranged for an issue of Yen bonds with a coupon of 6.65% p.a., 10 year maturity and face amount of 24,240,000,000, converted this to $120 million at the then spot rate of 202/$ and loaned the dollars to a counterparty at 10.7% p.a. Yen interest payments on the bonds were covered by means of a series of $/ forward contracts and the yen principal was left unhedged. The market rates at the time were :
At maturity of the yen bond issue (and the dollar loan), the worst-case scenario for BT is it will have to buy yen at the rate of 169/$. For $120 million this will yield 20,280,000,000 leading to a shortfall of [24240000000-20280000000] = 3,960,000000. This translates into an annual payment of 293,454,573. The net result is that BT realises a profit stream which is equivalent to a 10-year annuity of $1,566,024 at a discount rate of 10.5%. If all of this gain is passed on to LTCB (which is unlikely), LTCB's borrowing cost will come down to 10.2%
Lenders tend to be favourably biased towards political and legal systems that provides incentives to individual enterprise with minimum of government regulation, and fiscal and monetary conservatism.
Professional competence of key officials in the finance ministry and the central bank of the country, a well trained cadre of middle level officials, a relatively independent monetary authority, an efficient and facilitative bureaucracy and a government with the political will to implement tough decisions are highly valued Bankers prefer a long term development strategy that emphasizes output growth, stable prices, an "outward" orientation and "sound external finance". Administered interest rates, subsidies, administrative credit allocation, overvalued exchange rates, exchange controls etc. are generally frowned upon.