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Tarheel Consultancy Services

Corporate Training and Consulting

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Part-01
Financial Systems
Institutions, Instruments & Markets

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Barter system
&
Markets

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The “Markets”

 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

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Implicit Assumption

 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.

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Countertrade

 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

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Example of Barter
Telecom switches

AT&T Sevtelecom
Telecom company Currency Telecom company
USA & Apatite Russia
seller buyer

Apatite Helm AG
Trading Firm
Currency Germany
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Buyer & Seller
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Money
&
Markets

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Prior to
advent of
MONEY

Exchange your
Could not
Consume all the goods for other
put away goods
goods you have goods and then
for later use
consume them

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With the
advent of
MONEY

Everything could be Money gave you


The currency served
denominated in the freedom
as the medium
units of to
of exchange
the currency SAVE

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Markets
Services

Physical
Goods MARKETS
Assets

Financial
Assets
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Categories of Economic Units

Economic Units
transacting in
financial markets

Government Sector Business Sector Household Sector

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Income and Expenditure

Income = Expenditure

Balanced Budget Units (BBU)


Income > Expenditure

Surplus Budget Units (SBU)


Income < Expenditure

Deficit Budget Units (DBU)


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Function of a Financial System

funds
SBU DBU
claim

e.g. e.g.
•household •government
sector
•business
entities
•nation as a
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whole
IMPORTS EXPORTS

BALANCE OF TRADE

IMPORTS > EXPORTS = Trade Deficit


(Net borrower from abroad)

IMPORTS < EXPORTS = Trade Surplus


(Net lender and invest abroad)
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Introduction
to
Debt
&
Equity

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Financial Claims

funds
SBU DBU
claim

debt instrument

equity shares 17

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Debt Claims

funds

SBU DBU

debt instrument
or IOU

•Pay interest
at periodic
intervals
•Repay
principal at 18

maturity
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Equity Claims

funds

SBU DBU

Ownership or
equity shares
•Claim on profits
•Assets
remaining after
debtors have
been paid 19

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Liability

funds
SBU DBU
claim

ASSET LIABILITY 20

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Balance Sheet

Assets Liabilities

FUNDS CLAIMS
or
DEBT or borrowed capital
or
EQUITY or owners capital

Total Assets = Total Liabilities


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Balance Sheet

Assets Liabilities

Plant & Machinery $ 100 MM Share Capital $ 100 MM

Bank Deposit $ 100 MM Bonds $ 100 MM

Total Assets $ 200 MM Total Liabilities $ 200 MM


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Debt

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Short term
debt
instruments

Types of
debt
instruments

Long term
debt
instruments

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Long term debt securities

 Have a time to maturity of one year or more


 Issued by the government or by corporations

Bond Debenture
Firms also issue debt In the U.S a debenture is a
securities for which specific bond for which no assets of
assets are designated as the firm have been specified
collateral. as collateral.
Secured debt Unsecured debt
Note: In India the terms bonds and debentures are used interchangeably and thus 25
could refer to secured as well as unsecured debt Services
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Debt notes issued by the U.S. Dept of Treasury

long term
T-bonds time to maturity
10 – 30 years

medium term
T-notes time to maturity
1 – 10 years

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

Note: Terminology often differs across countries. 26

e.g. T-notes in Australia, Copyright


correspond to T-bills
Tarheel Consultancy in the U.S
Services
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 irrespective of whether or not it has made profits
 Interest payments have to be made before any
payments can be made to equity shareholders

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Debt (Cont…)
 Inthe 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 of the firm the claims of
the bondholders will be settled.
 Only if something were to remain will the equity
shareholders be entitled to stake a claim.
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Negotiable vs. Non-negotiable
Negotiable Non - Negotiable
 debt instruments debt instruments
 Can be freely traded Cannot be traded

Can be endorsed by one Cannot be transferred


party to another

e.g. e.g.
Treasury Bond bank loans
bank time deposits
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Break up of the U.S. Market
Type of Debt Amount in billions of USD

Municipal 2,018.60
U.S. Treasury 3,943.60
Mortgage Related 5,472.50
Corporate 4,704.50
Federal Agencies 2,745.10
Money Market 2,872.10
Asset-Backed 1,827.80
TOTAL 23,584.20
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Equity

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

shares

dividends

part owner Business


enterprise 32

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Dividends
 The rate of dividends is not fixed
 It is not contractually guaranteed

 Dividends can and do fluctuate from year to


year
 A company is under no obligation to declare
dividends in a particular year
 Good companies try to keep dividends at
steady levels to avoid sending wrong signals to
the outside world

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Retained earnings
A firm will not pay out its entire profits for the
year as dividends
 A fraction of the profits for the year 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.

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Equity (Cont…)
 Equity shares never mature, in the sense that
they have no expiry date.
 This is 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.
 That is, they can vote on various issues at the Annual
General Meetings of companies, including the election
of the board of directors.

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Equity (Cont…)

 Notall 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.

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Market Statistics
Number of companies listed on U.S Approx. 15,000
exchanges

Number of actively traded companies Approx. 1,000

Total dollar volume of trades on the 11,060


NYSE in 2000 (in billions )

Total dollar volume of trades on the 20,274


Nasdaq in 2000 (in billions )

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Preferred shares

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Debt Preferred Equity
shares

Promise a fixed rate of If firm is unable to pay as promised


return then shareholders cannot seek legal
recourse
In the event of liquidation, Dividends on preferred shares can be
preferred shareholders get paid only after a company has made
priority over equity interest payments on its outstanding
shareholders 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
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Example of a Tax Shield

 Consider two companies


 Pre-tax profit  $100,000
 Company A  0 interest liability
 Company B  $20,000 interest expense
 Tax rate  30%

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Example (Cont…)
Company A Company B

PBIT 100,000 100,000

Interest 0 20,000

PBT 100,000 80,000

Tax @ 30% 30,000 24,000

PAT 70,000 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)

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Derivatives

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Derivatives
Bonds
 These are essentially
contracts which are
Physical
Stocks
based on, or the assets
Derivative
demand for which is contracts
derived from, the
demand for an Stock
Foreign
market
underlying asset. currency
indices

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Classes of
derivative
securities

Forward Futures Options


Swaps
contracts contracts contracts

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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 delivery
fixed at of asset
outset pre specified time period

PRESENT FUTURE
No money Goods are
changes delivered
hands and money
is paid
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Example

price delivery
fixed at of asset
outset pre specified time period
PRESENT FUTURE
1 Nov 2003 15 Dec 2003
Vijay agrees to buy 100
kg of rice from Ajay on 15
Dec 2003 at Rs 14 per
kg. No money/assets
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change hands
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Example (Cont…)
 The contract is negotiated individually between Ajay and Vijay
 Such contracts are called OTC (Over-the-Counter) or customized
contracts
 No money changes hand on 1 Nov 2003
 The actual transaction will take place only on 15 Dec 2003
 The terms are set on 1 Nov 2003
 Both the parties have an obligation to perform
 Ajay is obligated to deliver the rice on 15 Dec 2003
 Vijay is obligated to accept the rice and pay the money on 15 Dec
2003

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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-The-
Counter 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
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Options
Contracts

Call Put
Option Option

•Gives the buyer the right •Gives the buyer the right
•To buy an underlying •To sell an underlying
asset asset
•On or before a pre •On or before a pre
specified date specified date 51

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•At a pre specified price
Forward/Futures Options
contract

Futures/forward contracts Call options give the holder


impose an obligation to buy the right to buy the underlying
the underlying asset, on the 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 Put option

If the holder of a call option If a put holder were to


decides to exercise his right to exercise his right, the seller of
buy, the seller of the option the put has an obligation to
has an obligation to deliver buy the asset
the underlying asset

Buyer 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
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Example of a Put Option

 Ajay buys a put option from Vijay


 Gives him the right to sell 100 kg of rice to Vijay at Rs
14 per kg on 15 December 2003
 Vijay will not give this right for free
 Ajay pays Rs 0.25 per kg or Rs 25 in all to acquire
this right
 This amount has to be paid at the outset and is called
the Option Price or Premium.

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Example of a Put Option
 Assume that the price of rice on 15 December 2003 is Rs.12 per
kg
 Ajay will most certainly exercise his option and ask Vijay to pay
Rs.1400
 This price of Rs.14 per kg is called the Strike Price or Exercise
Price
 Vijay cannot refuse since he has an obligation to perform
 What if the price on 15 December is Rs 16 per kg?
 Ajay will forget the option and sell the rice in the market for Rs 16
per kg
 He is in a position to do so since an option is a right and not an
obligation
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Example of a Call Option
 Assume that Vijay acquires the right to buy 100 kg of rice from
Ajay on 15 December 2003 at an exercise price of Rs.14 per kg
 Assume that the premium is Rs. 0.40 per kg.
 Consequently Vijay will pay Rs. 40 to Ajay at the outset
 Assume that the price of the asset on 15 December 2003 is
Rs.16 per kg
 Vijay will happily exercise his option and take delivery at the
exercise price of Rs.14
 Ajay cannot refuse since he has an obligation
 What if the price of rice on 15 December is Rs 12?
 Vijay will simply forget the option and buy from the market at Rs.12

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In summary
Instrument Nature of Buyer’s Nature of Seller’s
Commitment Commitment

Forward/futures Obligation to acquire Obligation to sell the


contract the underlying asset underlying asset

Call Options Right to acquire the Contingent obligation to


underlying asset deliver the underlying
asset

Put Options Right to sell the Contingent obligation to


underlying asset take delivery of the
underlying asset.

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Swaps

 These are contractual arrangements between


two parties to exchange specified cash flows at
pre-specified points in time

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Swaps

Interest
Currency
rate
swaps
swaps

Notional Principal
principal denominated in
two different
currencies 59

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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.

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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-rate-
variable-rate swap.

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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

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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

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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 country’s 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.

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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.
 All transfers are done electronically from one bank
account to another.

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Mortgage
A mortgage is a loan backed by real estate as collateral

Periodic
payments

Mortgagor Mortgagee
borrower lender

Can take
over
property 66

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An investor’s concerns

Returns

Time
Riskiness
pattern

Liquidity

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Returns •Cash
dividends
Returns •Capital
gains/losses

Time
Riskiness
pattern

Liquidity

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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 < Capital loss
 Inthe 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

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Risk

Returns

•May not
pay
dividends Time
Riskiness
pattern
•Capital
appreciation
may be
less/losses Liquidity
•Firm may
go into
bankruptcy
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Liquidity
 Liquidity may be defined as follows

 `It is the ability of market participants to transact quickly


at prices that are close to the true or fair value of the
asset.’

 `It refers to the ability of buyers and sellers to discover


each other quickly and without having to induce a
transaction by offering a large premium or discount.’

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Liquidity (Cont…)

 In liquid markets there will always be plenty of


potential buyers and sellers available.
 So traders will not be required to spend precious time
and money in locating counterparties.

 If a market is liquid  large trades will not have


a significant price impact.

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Liquidity (Cont…)
 In the absence of liquidity, large purchase orders
will send prices shooting up, while large sale
orders will end up depressing prices
substantially.
 Liquid markets in other words have a lot of
depth.
 Securities which trade in illiquid markets are said
to be thinly traded.

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Time pattern

Returns

•Cash flows
from bonds
Time are
Riskiness
pattern
predictable
•Cash flows
from
Liquidity dividends
can be
volatile

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A rational investor
H
I
Returns G
H

L Time
O Riskiness
W pattern

Liquidity

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Types of Rational Investors
Young investor Retired investor
Are more likely to prefer equities. Usually prefer to invest in bonds.
May be content with the For them, the key issue is the
possibilities of substantial capital availability of predictable periodic
gains cash flows from the asset

They may not require regular The key issue is the availability
cash flows immediately of predictable periodic cash
flows from the asset
More inclined towards risk Risk averse
Would of course demand Would be content with lower
adequate compensation by way returns
of higher expected returns 76

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Classification of Markets

Markets

Primary Direct Money


vs. vs. vs.
Secondary Indirect Capital

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Primary vs. Secondary Markets
PRIMARY SECONDARY
MARKETS MARKETS
Company offers new financial Once an asset has been bought
instruments to the investing by an investor from the
public. This very first issue of company, subsequent
shares by a company is called transactions in the instrument
an Initial Public Offering or IPO take place in the secondary
market
Companies issue shares and Secondary markets merely
bonds represent the transfer of
ownership of an asset from one
investor to another
Primary markets therefore
enable borrowers to raise funds 78

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Primary vs. Secondary Markets
PRIMARY SECONDARY
MARKETS MARKETS

TCS is issuing shares for the first ---


time to the public at Rs 850 per
share

Ravi applies for 1000 shares and Six months later Ravi sells these
is allotted 200 shares at a price shares on the National Stock
of Rs 850 Exchange for Rs 1250 per share

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Are Primary Markets Alone Sufficient?

 In order to facilitate savings and investment


in the economy we need both primary as
well as secondary markets

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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!

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In real life…
 Welike assets which can be easily liquidated or
converted into cash.
 Liquidity needs can never be perfectly anticipated we
need developed and active secondary markets, where
assets can be bought and sold easily.
 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.
 Quite obviously, all the companies will not experience
difficulties at the same time

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In real life

 Ourrisk 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.
 Once again, secondary markets are critical.

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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.

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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.
 In either case market intermediaries are
involved who facilitate a process of
`matchmaking’.

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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.
 Notonly should a counterparty be
available, there should be compatibility in
terms of price expectations and quantities
sought to be traded.

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Price Compatibility
 Every trader seeks to trade at a `good’
price.
 What is a good price?
 Buyers are on the lookout for 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.

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Quantity Compatibility
 The quantity being offered should match
the quantity being demanded.
 Often a large sell order may require more than
one buyer to take the opposite position before
getting fully executed.
 The same is true for large buy orders.

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Market Intermediaries

Brokers

Market
Intermediary

Investment
Dealers
Bankers

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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

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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.

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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

Replenish inventory later at lower price 92

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Dealers

Sell@Ask - Buy@Bid = Profit = Spread

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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.
 Theseinclude 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.

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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.

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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

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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.

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Best Efforts

 Attimes, 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.

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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.

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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.

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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.
 Companies who seek to retain an option to issue
additional shares in the event of
oversubscription are said to have a Greenshoe
option.
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Underwriting (Cont…)

 E.g.The CIT Group came out with an IPO in


2000
 Offered 200 million shares
 Plus a greenshoe option for 20 million shares that could
be purchased by the members of the underwriting
syndicate at the offer price of $ 23 within 30 days from
the date of the issue.
 The greenshoe option is also called the overallotment
option.

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Underwriting (Cont…)
 The underwriting fee compensates the
investment bank for the sales effort as well as
for the insurance service provided to the issuing
company.
 Since a best efforts offer does not involve the insurance
component, the corresponding fees and commissions
tend to be lower.
 Underwritingfees 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.

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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.
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Glass-Steagall (Cont…)
 The Act thereby segregated Investment Banking
& Brokerage Operations from Commercial
Banking.
 In 1971 the Supreme Court passed a ruling
allowing commercial banks to set up holding
companies, which could then set up a separate
subsidiary for brokerage operations.
 Brokerage companies set up by such holding
companies came to be known as section 20 brokerage
firms.

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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.

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Top Underwriters of U.S. Debt and
Equity as of 1996
FIRM Amount in Billions Market Share
Merrill Lynch 155.90 16.40%
Lehman Brothers 100.70 10.60%
Goldman Sachs 98.50 10.30%
Salomon Brothers 96.20 10.10%
Morgan Stanley 83.70 8.8%
J.P. Morgan 68.70 7.20%
CS First Boston 60.00 6.30%
Bear Stearns 41.70 4.40%
Donaldson, Lufkin 34.80 3.60%
Smith Barney 29.90 3.10%
Top 10 Firms 770.10 80.80%
107

Industry Total 953.40


Copyright Tarheel Consultancy Services 100.00%
Indirect Markets BORROWE
R
LENDERS

LENDER
individual
Corporate
borrower
family

Commercial
bank

Non – corporate
Financial borrowers
claims

Financial 108

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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

109

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In. Market Intermediaries
Insurance
cos

I. Market
Intermediary

Pension Mutual
funds funds

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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.

111

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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

112

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Indirect Markets BORROWE
R
LENDERS

LENDER
individual
Corporate
borrower
family

Commonwealth
Bank
5% pa
4% pa
Telstra etc.

Financial
claims

Financial 113

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Illustration (Cont…)

 Assume that Telstra can directly issue bonds to


the public, with a coupon rate of 4.75%.
 Investors  get 0.75% extra as compared to bank
deposit
 Telstra  Will save 0.75% as compared to borrowing
from the bank
 Bank’s margin of 1.5% has been shared by the
company & investors

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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
 E.g.
A firm issues bonds with a face value of $100,000  small
investors will be unable to subscribe.

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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

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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

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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.

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The Role of Intermediaries (Cont…)
 Financial institutions also facilitate risk
diversification.
 Diversification means that `don’t 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.
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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

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Money Mkts. vs. Capital Mkts.
Money Markets Capital Markets

Time to maturity at the time of issue Markets for medium to long term
is one year or less instruments
Money market instruments by Capital market securities include
definition have to be debt instruments both long and medium term debt as
well as equities
Money markets are used to adjust Capital markets channelize funds
temporary liquidity imbalances. In from those who wish to save to those
practice, for any company, inflows who seek to make long term
and outflows at any point in time will productive investments
rarely match
Money markets help firms to borrow Capital markets are where
short term and also to deploy surplus companies source funds for their long
funds on a short term basis term investment needs
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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

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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

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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

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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

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Historically Today
Open-Outcry: Historically trading These days most exchanges are
on exchanges has taken place on electronic communications
trading rings / floors networks and most traders no
The BSE used to have this
longer interact face to face
system until it introduced online
trading
Many older exchanges (e.g.
NYSE) have a combination of floor
based and electronic trading

Traditionally exchanges have Of late many exchanges are


been owned by the member characterized by corporate
brokers and dealers ownership. Such exchanges are
said to be demutualized
The NSE is owned by a number
of institutions such as IDBI, LIC
etc.
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Examples of Demutualized Exchanges

 The NASDAQ
 The Stockholm Stock Exchange
 The Toronto Stock Exchange
 The Deutsche Borse
 The National Stock Exchange
 The Chicago Mercantile Exchange

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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
 In the U.S. about 8,250 stocks are listed on the major
exchanges. Only a small fraction of these are actively
traded
 On the NYSE the 250 most active stocks accounted for
62% of the reported trading volume, and an even larger
percentage of the dollar volume in 2000
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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.

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Listing and Registration
Listing Registration
There is no legal requirement Registration is mandatory and
that a company should get its requires the submission of
shares listed on an exchange 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
Practices (GAAP) 130

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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

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Listing Fees on the NYSE (as of 2002)

 Original listings (one time fee per company): $ 36,800


 Initial Fees (rates per million shares)
 1st and 2nd Million - $ 14,750
 3rd and 4th Million - $ 7,400
 5th and up to 300 million - $ 3,500
 In excess of 300 million - $ 1,900
 Minimum original listing fee (including special charge): $ 150,000
 Maximum original listing fee (including special charge): $ 250,000
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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

 AMEX

 NASDAQ

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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

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The Third Market
A collection of dealers and brokers who arrange
trades in exchange listed stocks, away from the
exchange
History Today
Began to develop when These quotes are displayed on
institutional investors became the Nasdaq Intermarket
dissatisfied with the liquidity
and commissions for large
trades on the exchanges
Used by traders to trade large
blocks without alerting the
market 135

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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 an
offsetting position 136

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The Fourth Market (cont…)
 E.g.:
 Island ECN
 Instinet

 REDIBook

 Archipelago

 Bloomberg Tradebook

137

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International Stock Exchanges

 Over the past two decades exchanges have


mushroomed across the globe
 Happened due to the increasing acceptance of 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

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International Exchanges
Successful exchange development requires

Strong property rights Successful privatization


programs

Strong contract laws and Regulatory authorities with


securities regulation laws teeth

 Deutsche Borse  Italy  Korea


 Euronext  Stockholm  Osaka
 London  Switzerland  Taiwan
 Australian
 Madrid  Tokyo
 Hong Kong 139

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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.

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Bond Markets (cont…)
 The number of government bond issues is less,
but the issue sizes are much larger
 These bonds are more actively traded
 Mostcorporate 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 volume
occurs on the NYSE and the AMEX bond markets
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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.

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Derivatives Markets

 There are 5 exchanges in the U.S that trade


options contracts on equity shares and stock
market indices
 Buyers can buy contracts on a particular exchange and
sell them on another exchange, thereby neutralizing or
offsetting their positions
 Investment banks trade options contracts OTC

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Derivatives Markets (Cont…)

 Outsidethe U.S most stock options contracts


trade on the same stock exchange where the
underlying stocks are traded
 E.g. Both underlying stocks as well as stock options
trade on the NSE
 The SEC has not permitted equity shares and
options written on them to trade side by side.
 Even when they trade on the same exchange,
they do so in different rooms. 144

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Derivatives Markets (Cont…)

 Futures contracts trade on futures exchanges.

 In the U.S. stock index options also trade on

futures exchanges.

 In most other countries, stock index options

trade on stock exchanges.

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Actors or Players
 Traders in the market can be divided into two categories.

Those who trade on their own Those that arrange trades for
account others

Proprietary traders trade on Agency traders act on behalf


their own account of or as agents of others who
wish to trade

They are also known as


brokers, commission traders,
or commission merchants (in
futures markets). 146

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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

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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
 Howcan 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
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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

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Buy Side & Sell Side
 The trading industry
Buy side Sell side
can be classified into
traders who traders who
a buy side and a sell seek to buy the offer the
side services offered services of the
by the exchange exchange
 The most important of
these services is
liquidity traders are traders are
those in search those who
 The terms buy side and
of liquidity supply liquidity
sell side have nothing
to do with the actual
traders on both sides regularly
buying and selling of buy as well as sell securities
securities 150

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Buy side Sell side
Refers to the portion of the Consists of brokers and
securities business in dealers who help buy side
which primarily institutional traders to trade at their
orders originate convenience
This is selling liquidity
Funds (mutual and pension) Market makers
Firms Specialists
Governments Floor Traders
Insurance Companies Locals
Charitable and Legal Trusts Day Traders
Scalpers 151

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Examples - The Sell Side

 Brokers are of various types.


 Retail brokers – Charles Schwab
 Discount brokers – E*Trade
 Full service brokers – Dreyfus
 Institutional brokers – Abel/Noser Corporation
 Futures Commission Merchants – Cargill Financial
Markets Group

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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

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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

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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

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Clearing
 What is clearing?
When a trade occurs:
(either on the exchange floor, or over the telephone):
•Both parties will make a record of the terms of the trade
& the identity of the counterparty

Before the trade is settled:


•The two records must be compared to ensure that the
facts and figures tally.
This is called clearing 156

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Clearing Agents

 Clearing agents are entities which match and verify


records, in order to confirm that both the parties have
agreed on the same terms and conditions.
 E.g. The largest clearing agency in the U.S is the National
Securities Clearing Corporation (NSCC)

157

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Clearing Agents (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 (Don’t Knows)
In the futures markets they are called Out Trades 158

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Clearing Agents (cont…)
History Today

Orders are manually matched In electronic systems, the


orders are matched by the
computer, which contains all
the required information about
the orders

Clearing is a very important Consequently clearing


exercise in the context of becomes a trivial exercise
conventional manual
exchanges

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Settlement Agents
 What do we mean by settling?
 Payment of cash by the purchaser & the delivery of
securities by the seller
 The job of a settlement agent is:
 receive the cash from one party
 receive the securities from the other party
 ensure that the amounts are in order
 pass the cash/securities to the counterparty
 E.g. The largest settlement agent in the U.S is the
NSCC, which is not surprising since clearing and
settlement are related functions
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Settlement (Cont…)

 Normal-way settlement in the U.S occurs 3


business days after the day of trade.
 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.

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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 Company (DTC), which holds
nearly 20 trillion dollars in assets

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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.

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Depositories & Custodians

 They facilitate the settlement process by quickly

transferring cash and securities to settlement

agents upon receiving instructions from the

traders.

164

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Arbitrage

 What is arbitrage?
 Arbitrage may be described as the existence of the
potential to make riskless profits by transacting in

multiple markets.

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IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £

Borrow $18,000. Sell on LSE for


Buy 100 shares £10,000
on NYSE
Transfer
$20,000 back to NY

Profit = $2000 166

This transaction is Tarheel


Copyright costless and
Consultancy risk-less in a perfect
Services
These opportunities cannot persist for long
IBM shares
NYSE LSE
$180 per share £100 per share
Exchange rate 2 $/ £

Buy on NYSE Sell on LSE


Price rises Price falls

Exchange rate will come down from 2 $/ £

167

Equilibrium isServices
Copyright Tarheel Consultancy restored
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.
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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.
 Thus the kind of arbitrage described is often
feasible for such investors, who will
consequently exploit such situations till they
cease to exist.
169

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IBM shares
NYSE LSE
$180.75 / $181.25 £100.25 / £100.5
Exchange rate 2.05/2.15 $/ £

Borrow $18,125 Sell on LSE for


Buy 100 shares £10,025
on NYSE
Transfer
$20,551.25 back to NY

Profit = $2426.25 170

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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?

171

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IBM shares
NYSE LSE
$180.75 / $181.25 £100.25 / £100.5
Exchange rate 2.05/2.15 $/ £

Borrow $18,135 Sell on LSE for


Buy 100 shares £10,020
on NYSE
9995 x 2.05 = Transfer
$20,489.75 back to NY

Profit = $2354.75 172

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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
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Eurocurrency Markets
 Thesedeposits 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.

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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.
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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.
 Under a legislation called ‘Regulation Q’, the
U.S. government imposed low interest rate
ceilings on bank deposits and simultaneously
specified high reserve limits
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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?

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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.
 Theobjective is to bolster the safety of the
deposit holders.
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Should we set reserves at a high level?

 Obviously the higher the reserve percentage, the


greater is the safety for the depositors
 Onthe 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

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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

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Reserves
Statutory Liquidity Ratio (SLR):
25% of the deposit has to be maintained in the form of
approved government securities

Cash Reserve Ratio (CRR):


4.5% of the deposit has to be maintained as cash with the
RBI

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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.

 Recently the RBI has started allowing interest on

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Example - Reserves
 Dueto high reserve requirements American
banks could not offer attractive rates on
deposits.
 ‘Regulation Q’ made matters 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
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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
 These factors offer enormous flexibility to banks

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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

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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

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Floating Rate Loans
History Today
Loans have been made on The growth of the
the basis of a fixed rate Eurocurrency market has lead
to loans based on floating
rates of interest

The interest rate remains The interest rates on such


fixed for the tenure of the loan loans are not constant, but
are linked to a benchmark.
Consequently they vary with
changes in the level of the
benchmark.
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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
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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

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Basis Point

 What is a basis point?


 A basis point is one hundredth of one percent

 100 basis points = 1 percentage point

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Example
 Loan amt = $ 100,000
 Interest payable -> semi-annually

FIXED RATE LOAN FLOATING RATE LOAN


 annual interest rate =  annual interest rate = LIBOR +
10% 50 basis points (0.50%)
 Interest payable every  current LIBOR = 8% pa

six months = $ 5,000  Interest payable for the next


six months:
 (.08 + .005) x 0.5 x
100,000 = $ 4,250
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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

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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:

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International Bond Market
 Borrowers issue
bonds in the International
international market Bond Market
to raise medium to
long term funds.
 Borrowers  MNCs,
governments, financial
institutions.
 High Net Worth (HNW)
investors use these Eurobond Foreign bond
markets for risk segment segment
diversification
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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

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Eurobonds - Illustration

 Sony is issuing bonds in  IBM is issuing bonds in


Japan: Japan:
 Issuer = Japanese company  Issuer = American company
 Principal = $10 billion  Principal = $10 billion

 Currency of issue = USD


 Currency of issue = USD

 Currency of Japan = Yen


 Currency of Japan = Yen

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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

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Foreign bonds - Illustration
Not a Foreign Bond Foreign Bond
 Sony is issuing bonds in  IBM is issuing bonds in

Japan: Japan:
 Issuer = American company
 Issuer = Japanese
 Principal = 10 billion
company
 Currency of issue = Yen
 Principal = 10 billion
 Currency of Japan = Yen
 Currency of issue = Yen
 Currency of Japan = Yen

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Foreign Bonds

 Foreign bonds have nicknames


 U.S.  Yankee bonds

 Japan  Samurai bonds

 U.K.  Bulldog bonds

 Australia  Kangaroo bonds

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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
1. 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
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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

3. Interest paid on such bonds is not subject to withholding taxes


a.k.a. TDS in India

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History of Eurobonds
 Due to  Foreign  Investors
‘Regulation Q’, companies were flocking
U.S financial were issuing to these
institutions Yankee bonds
Yankee
could not offer with relatively
bonds
high rates of attractive rates
interest of interest

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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

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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.

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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

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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.
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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.
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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’.
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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

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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
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Advantages of Dual Listing

 Foreign listings provide MNCs with indirect


advertising for their product brands
 Itraises 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.
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GDRs and ADRs

 Foreign equity is traded Depository


Receipts
on international markets (DRs)
in the form of Depository

Receipts.
Global American
Depository Depository
Receipts Receipts
(GDRs) (ADRs)
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What is an ADR?

A special share of foreign equity priced in U.S.D.


 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

issuer’s country

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An ADR issue process

India India

Domestic Custodial
shares Bank
Wipro SBI

Depository
ADRs
Bank
USA USA
JP Morgan 214

Bank
Copyright of New
Tarheel YorkServices
Consultancy
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

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Illustration

India USA

Domestic
ADRs USA
shares
1 ADRs =
Rs. 30 / share 60c /share 10 domestic
shares
$6 /share

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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 and
depository will in turn have the ADRs acquired in lieu
equivalent number of shares sold
in the home market

Less attractive from the standpoint Required to ensure that there are
of an American investor no arbitrage opportunities between
the U.S and the home market

Has potential to reduce liquidity


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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

Domestic
ADRs
shares
Overvalued Buy in India
hence shortsell Convert to ADRs
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Arbitrageur – Infosys ADR overvalued

USA Exch rate Rs. 50/dollar India

1 ADR =
Domestic
10 domestic
shares
shares
$210 / ADR Rs.1000 /share

Shortsell 1 ADR(+$210) Acquire 10 shares (-Rs.10,000)


$200
Convert
Profit = $10
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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

Domestic
ADRs
shares
Undervalued Sell in India
hence buy

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Convert
Copyright to domestic
Tarheel shares
Consultancy Services
Arbitrageur – Infosys ADR undervalued

USA Exch rate Rs. 50/dollar India

1 ADR =
Domestic
10 domestic
shares
shares
$190 / ADR Rs.1000 /share

Buy 1 ADR(-$190) Sell 10 shares (+Rs.10,000)


$200
Convert

Profit = $10
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ADRs - History

 The first ADR was created by J.P. Morgan in


1927.
 From the standpoints of clearing and settlement:
 ADR a domestic U.S security
 Traded on NYSE, AMEX, Nasdaq, and OTC markets
 1996: $13,655 billion worth of DRs were raised through
80 public offerings by companies from 80 countries.

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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.

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Levels of ADRs

Levels of
ADRs

Unsponsored Sponsored Sponsored Sponsored


ADRs Level-1 ADRs Level-2 ADRs Level-3 ADRs

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Unsponsored Sponsored Sponsored Sponsored
ADRs Level-I ADRs Level-II ADRs Level-III ADRs

issued by do not require require financial require even


depositories in compliance with statements more paperwork
the U.S in U.S. GAAP, or conforming to
response to disclosure U.S. GAAP, and
market demand beyond what is disclosure in
required in the accordance with
home country SEC regulations

issues are not can be traded on can be traded on allow issuance


initiated by the OTC mkts in the U.S. exchanges and sale of new
parent foreign U.S. and on shares to raise
company some exchanges equity capital in
outside the U.S the U.S.

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Benefits to Issuers
 Company’s 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

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Benefits to Holders

 Get access to assets which are quoted in


USD and trade like any U.S. security
 Get dividends in USD

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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.

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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
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IBFs - History
History Today

To allow U.S. banks to Over 75% of the deposits are


compete effectively with with IBFs located in New York
offshore banks (Eurobanks) State
without having to set up an
office offshore

California and Illinois are the


other states with significant
IBF activities

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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

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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.’

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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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