International Financial Management

P G Apte

P.G.Apte International Financial Management 1

 19.1 Introduction
• Phenomenal changes have swept financial markets
around the world during the 1980's and the 1990s
• Financial markets everywhere serve to facilitate
transfer of resources from surplus units (savers) to
deficit units (borrowers), the former attempting to
maximise the return on their savings while the
latter looking to minimise their borrowing costs
• An efficient financial market thus achieves an
optimal allocation of surplus funds between
alternative uses and healthy financial markets also
offer the savers a wide range of instruments
enabling them to diversify their portfolios
P.G.Apte International Financial Management 2
 19.1 Introduction (contd.)

• 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

P.G.Apte International Financial Management 3

 19.1 Introduction (contd.)

• 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
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 19.1 Introduction (contd.)

• 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

P.G.Apte International Financial Management 5

 19.1 Introduction (contd.)
• 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

P.G.Apte International Financial Management 6

 19.1 Introduction (contd.)
• By and large, India's borrowings have been by
way of syndicated bank loans, buyers' credits and
lines of credits
• 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
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 19.2 The Major Market Segments

• The funding avenues potentially open to a

borrower in the global capital markets can
be categorised as follows
– Bonds
• Straight Bonds
• Floating Rate Notes (FRNs)
• Zero-coupon and deep discount bonds
• Bonds with a variety of option features embedded in
them

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 19.2 The Major Market Segments
(contd.)
• Syndicated Credits
– These are bank loans, usually at floating rate of interest,
arranged by one or more lead managers (banks) with a
number of other banks participating in the loan
• Medium Term Notes (MTNs)
– Initially conceived as instruments to fill the maturity
gap between short-term money market instruments like
commercial paper and long-term instruments like
bonds, these subsequently evolved into very flexible
borrowing instruments
P.G.Apte International Financial Management 9
 19.2 The Major Market Segments
(contd.)
• Committed Underwritten Facilities
– The basic structure under this is the Note
Issuance Facility (NIF), these instruments
were popular for a while before introduction of
risk-based capital adequacy norms rendered
them unattractive for banks
• Money Market Instruments
– These are short-term borrowing instruments
and include commercial paper, certificates of
deposit and bankers' acceptances among others
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19.2 The Major Market Segments (contd.)

• Another innovation to have emerged during the

last decade or so is Project Finance and its
novelty lies in the way the financing package is
put together including the rights and obligations of
the parties involved, allocation of various
operating and financial risks to those who are best
equipped to bear them, incorporation of various
guarantees and so forth

P.G.Apte International Financial Management 11

19.2 The Major Market Segments (contd.)

• Most of the funding instruments discussed above

also have their "domestic" and "offshore"
segments
• Borrowers often access a currency-market
segment which offers ease of access, cheaper all-
in cost or some other attractive feature and then
use swaps to reconfigure their liabilities in terms
of currency and interest rate basis

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19.2 The Major Market Segments (contd.)

• Bond Markets
– A bond is a debt security issued by the
borrower, purchased by the investor, usually
through the intermediation of a group of
underwriters
• Straight Bond
• Callable Bond
• Puttable bond
• Sinking Fund Bond

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19.2 The Major Market Segments (contd.)

• FRN
• Zero Coupon Bond
• Convertible Bond
• Warrants
– A large number of other variants have been
brought to the market

P.G.Apte International Financial Management 14

19.2 The Major Market Segments
– Eurobond Market : Unregistered bearer bonds
Foreign Bonds : Non-resident issues in domestic
markets
– Yankee Bonds : Public Issues in the US markets;
listed, registered. Strictly regulated.
– Private placements possible
– Samurai Bonds : Public Issues in the Japanese Market
– Shibosai Bonds, Shogun Bonds and Geisha Bonds
(Private placements in the Japanese market)
– Swiss and German Bonds
– Bulldog Bond (Public issues in UK)
– Rembrandt Bonds (Holland)

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•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 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: Unpublicised, private arrangements
–Revolving Credit

P.G.Apte International Financial Management 16

19.2 The Major Market Segments
(contd.)
– 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 too
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 19.2 The Major Market Segments
(contd.)
• MTNS and EMTNs
– The main advantage of borrowing via an MTN
or EMTN programme is its flexibility and much
less onerous formalities of documentation
compared to a bond issue
– The market is accessible only to issuers with
good credit rating

P.G.Apte International Financial Management 18

 19.2 The Major Market Segments
(contd.)
• 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

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19.2 The Major Market Segments
(contd.)
– If at any roll-over the borrower is unable to
place the entire issue with the market, the
underwriting banks either take up the remainder
or provide a short-term loan and the
arrangement under which the banks provide
credit to make up the shortfall is known as a
Revolving Underwriting Facility (RUF)

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 19.2 The Major Market Segments
(contd.)
• 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

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19.2 The Major Market Segments
(contd.)
– 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)

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 19.2 The Major Market Segments
(contd.)
– Concept of co-finance
– 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

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

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 19.3 The International Financing
Decision (contd.)
• The critical dimensions of this decision for
a firm to chose funding avenues
– Interest rate basis : Mix of fixed rate and
floating rate debt
– Maturity : The appropriate maturity
composition of debt
– Currency composition of debt
– Which market segments should be tapped

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

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 19.3 The International Financing
Decision (contd.)
• Overriding these considerations are issues
of regulation and market access
• In viewing the risks associated with funding
activity, a portfolio approach needs to be
adopted
• Currency and interest rate exposures arising
out of funding decisions should not be
viewed in is

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 19.3 The International Financing
Decision (contd.)
• In evaluating a particular borrowing
alternative the following parameters have to
be examined under alternative scenarios
– The all-in cost of a particular funding
instrument
– Interest rate and currency exposure arising from
using a particular financing vehicle

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 19.3 The International Financing
Decision (contd.)
• Consider a firm which is contemplating a
fixed rate foreign currency loan (or a fixed
rate foreign currency bond issue)
– The nominal rate of interest is I (expressed as a
fraction not percentage), the maturity is N
years, interest is paid annually and repayment is
bullet
– The principal amount is A

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19.3 The International Financing
Decision (contd.)
– The rate of exchange at time t is denoted St
expressed as units of home currency per unit of
foreign currency
– The real cost of this loan consists of three
components viz. the nominal interest,
appreciation of the foreign currency and
domestic inflation is R = I + ŝ - π
– ŝ denotes proportionate change in the spot rate
and π is the domestic rate of inflation
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19.3 The International Financing
Decision (contd.)
– The variance of the real cost therefore is
Var(R) = Var(ŝ) + Var (π) - 2Cov (ŝ, π)
– To compare the variances of real costs, the
covariance term is important
– Between two currencies, if the variance of both
is nearly equal, the one which obeys PPP with
the home currency more closely will have a
lower variance of real cost of borrowing

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19.3 The International Financing
Decision (contd.)
– If the real cost risk is ignored, the choice of
currency should be based on a comparison of
effective interest rates which consist of the
nominal interest rate I, and the expected rate of
appreciation of the foreign currency Se
– When the nominal interest rate itself is not
fixed - as with a floating rate loan or FRNs - an
additional source of risk is introduced viz. the
variance of the nominal interest rate and its
covariances with the exchange rate and
domestic inflation rate
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 19.4 Summary
• Various segments of the global debt market
• The markets are in a constant state of flux with new
instruments emerging and some of the old ones going into
a decline
• Various dimensions of the international financing decision
• Effective cost of borrowing via a particular vehicle,
considerations of exchange rate and interest rate exposure,
market access and portfolio diversification issues are
critical
• Exchange rate and interest rate risks must not be viewed in
isolation for each particular financing decision but as a
component of the global corporate portfolio of assets and
liabilities
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