MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit V: Managing Foreign Operations
Lesson 5.2

( Euro currency Market,ADR, GDR, SWAPs Currency and Interest rate swaps)

Introduction
When the foreign exchange crisis hit the economy
in mid-1990, Indias credit ratings were
downgraded significantly and all external funding
avenues were closed. After liberalization, Indian
companies started exploring the global market
once again. Unlike the earlier, when funds were
raised by World bank , Asian Development bank,
companies began looking at bonds and equities
from international markets which are collectively
called as Euro Issues.
Fund raising from International
markets
The two mechanism used by Indian companies are
a) Depository Receipts, and
b) Foreign Currency Convertible Bonds (FCCBs)
/Eurobonds

Euro Issues are simply means of raising funds in the
institutional market, and have no special connotation or
legal meaning. The term Euro Issue is really a misnomer ,
as initially these instruments were normally traded in
European market but now they expanded to tap the
global market and not just Europe.
Fund raising from International
markets
Investors invest in foreign markets:
to take advantage of favorable economic
conditions;
when they expect foreign currencies to appreciate
against their own; and
to reap the benefits of international
diversification.
Motives for Using
International Financial Markets
Creditors provide credit in foreign markets:
to capitalize on higher foreign interest rates;
when they expect foreign currencies to appreciate
against their own; and
to reap the benefits of international
diversification.
Motives for Using
International Financial Markets
Borrowers borrow in foreign markets:
to capitalize on lower foreign interest rates; and
when they expect foreign currencies to depreciate
against their own.
Motives for Using
International Financial Markets

Difference between Domestic Issues
and Euro Issues
Particulars Domestic Issues Euro Issues
Pricing of Issues Pricing of the issue is done
in advance.
Pricing is done on the date
of issue.
Issue period The issue has to remain
open for a minimum of
three days.

No such requirement.
Contents of prospectus Projected earnings ,
appraisal of project from
Financial institutions is
desirable.
Any kind of projections are
prohibited.
Highlights /risk factors Highlights and risk factors
must be mentioned.
Not required.
Subscription Subscription is required
from General public.
Can be subscribed only by
Qualified Institutional
investors.

Difference between Domestic Issues
and Euro Issues
Particulars Domestic Issues Euro Issues
Regulatory framework The regulatory framework
is dictated by SEBI, RBI and
the concerned stock
exchanges.
The regulations to be
followed are dictated by the
Ministry of Finance , RBI ,
Department of Company
Affairs and the concerned
stock exchanges.
Governance It is governed by local laws. It is governed by
international laws.
Name of security holder The securities are held in
the name of the investor.
The securities are held in
the name of overseas
depository.
Size of issue No upper limit to the size of
the issue.
The amount raised cannot
exceed 51% of the capital
of company.
Terms of payment The subscription payment
terms are flexible.
One time payment must be
done.
Depository Receipts- ADR and GDR
Depository receipts facilitates companies in
developing countries to raise funds in hard
currencies like dollar from developed countries.
If an Indian company intends to raise money
from abroad , it will be required to list its shares
in European or American markets. But due to
stricter norms , it is difficult for them to seek
listing of their shares abroad. To avoid stricter
norms , depository receipts can be issued and
funds can be mobilized.

Depository Receipts- ADR and GDR
A foreign investor who intends to purchase shares in
Indian company can do so by purchasing depository
receipt of the company from the Depository or the stock
exchange where it is being traded. A depository
represents certain number of specified shares. Thus, an
investor holding depository receipts is not in the physical
possession of the equity shares. When a company
declares its dividend , it is paid in domestic currency
which is converted into foreign currency by the
depository and finally paid to the foreign investor. Thus,
the main advantage to a company issuing ADR /GDR is
that though the inflow is in terms of foreign exchange,
the outflow is in its home currency.


Depository Receipts- ADR and GDR
Mechanics of DR issue
In a GDR issue, a company issues ordinary shares and
delivers these ordinary shares to a domestic custodian
bank.

This bank will, in terms of the agreement, instruct an
overseas depository bank to issue securities in the nature
of Global Depository Receipts or Certificates, against
these shares lying with custodian.

These GDRs are issued to a non-resident investor
against the shares held by the domestic custodian bank.
Depository Receipts- ADR and GDR
Mechanics of DR issue
Each depository receipt represents a multiple
number of a underlying shares, say 1GDR = 10
shares.
GDRs are negotiable certificates and denominated
in U.S. dollars. They are listed on a European stock
exchange often Luxembourg or London. However,
Luxembourg is generally preferred because of less
disclosure requirements.
Depository Receipts- ADR and GDR
A depository receipt represents a particular bunch
of shares on which the receipt holder has the right
to receive dividend, other payments and benefits
which the company announces from time to time
for the shareholders. It is non-voting equity holding.
The issuer firm pays dividend in terms of domestic
currencies which is converted into the hard currency
by the depository and paid to the depository
holders. This way of listing shares in the form of
depository receipts avoids the listing fees, disclosure
norms and reporting requirement which would have
been obligatory on the company issuing shares.

Depository Receipts- ADR and GDR
The main advantage of the GDRs to the issuer is
that the company does not assume any foreign
exchange risk. Although it is able to garner
foreign exchange by way of issue proceeds. The
dividend outflow from the company is only in
rupee terms, but the depository converts these
rupees and pays the dividend in US dollar terms
to ultimate investors after deducting a
withholding tax .

Depository Receipts- ADR and GDR
GDRs and ADRs are identical from a legal,
operational, technical and administrative
standpoint. The word global is used when
securities are to be issued on a global basis, that
is to investors not restricted to the US. However,
accounting and disclosure standards as far as
ADRs are concerned, are more stricter than
GDRs.

Depository Receipts- ADR and GDR
Benefits to the Issuing Company
Enables to enlarge the market for its shares
and diversify investors base.
Enhances the image of the companys product,
services, in a market place outside their home
country.
Provides a mechanism for raising capital or as a
vehicle for an acquisition.


Depository Receipts- ADR and GDR
Benefits to the Investors
GDRs are quoted in dollars, and interest and
dividend payments are also in dollars.
Enables mutual funds, pension funds in
acquiring and holding securities outside their
domestic markets.
GDR overcome foreign investment restrictions.


Foreign Currency Convertible Bonds
(FCCBs)

FCCBs are debt instruments , with the option to
convert them into a predetermined number of
equity shares. ( Like convertible debentures in
domestic markets). The investors receives a fixed
rate of interest and has the option to convert the
bond into a fixed number of equity shares at the
option of the holder. They are also called as
Eurobonds.
Foreign Currency Convertible Bonds
(FCCBs)

FCCBs are debt instruments , with the option to
convert them into a predetermined number of
equity shares. ( Like convertible debentures in
domestic markets). The investors receives a fixed
rate of interest and has the option to convert the
bond into a fixed number of equity shares at the
option of the holder. They are also called as
Eurobonds.
Different types of International Bonds
A Eurobond is a bond that is issued by an international borrower and sold to
investors in countries with currencies other than the currency in which the bond
is denominated. An example of a Eurobond is a dollar-denominated bond issued
by a U.S. company and sold to Japanese investors. A Eurobond is typically issued
in a single currency (frequently dollars) in many countries. By selling Eurobonds,
many multinational companies finance their global operations especially in the
countries in which they are do business.

Parallel Bonds are those bonds issued in number of countries simultaneously
where the borrower obtains funds from a number of countries in the currencies
of those countries.


Different types of International Bonds
Foreign Bond
In contrast to a Eurobond, a foreign bond is a bond issued in a host countrys
financial market, in the host countrys currency, by a foreign borrower. This bond
is subject to the regulations imposed on all securities traded in the national
market and sometimes to special regulations and disclosure requirements
governing foreign borrowers. Many of these issues have colorful nicknames such
as:
Yankee bonds: dollar-denominated bonds which are issued by non-American
borrowers in the U.S. market.
Samurai bonds: yen-denominated bonds which are issued by non-Japanese
borrowers in the Japanese market.

Euro currency Market
A Euro currency is any freely convertible currency
deposited in a bank outside its country of origin.
For example, Pounds which are deposited in US
become euro sterling, dollars deposited in London
becomes Euro dollar.
The Euro currency market consists of those banks
which accept deposits and make loan in foreign
currencies. For example, a company in UK
borrowing US dollars from a bank in France is
using a Euro currency market.


Euro currency Market
For a Eurocurrency market to exist three conditions
must be met.
a) National Government must allow foreign currency
deposits to be made.
b) The country whose currency is being used must
allow foreign entities to own and exchange
deposits in that currency.
c) There must be a , significant reason, such as low
cost or ease of use that motivates individuals to
use this market and not the domestic one.

Swaps
A swap is an agreement between two parties
to exchange sequences of cash flows for a set
period of time. Usually, at the time the
contract is initiated, at least one of these
series of cash flows is determined by a
random or uncertain variable, such as an
interest rate, foreign exchange rate, equity
price or commodity price.

Swaps - Example
Consider the following case
Three Parties involved:
Company A ( Low rating)
Company B ( High rating
A Bank (AA rated)
Starting Positions:
Company A has low credit rating and wants to raise
long term funds which are available at high cost.

Company B has good crediting rating have easy
access to long term funds at lower cost but requires
short term funds.

Swaps - Example
Borrowing costs before swap (%):

Fixed Rate Floating Rate
Company A 10.00 LIBOR + .80
Company B 8.85 LIBOR + .30
Difference 1.15 .50

Comparative advantage = ( 1.15 0.50) = 0.65

Company B enjoys a lower borrowing cost in both markets.

But, Company A has relatively lower costs in floating rate mkt.

The differences in cost (under fixed rate and floating rate) is a
comparative advantage of 65 basis point (115 - 50). This 65 basis point
comp. Advantage is the amount of potential savings from the swap.
Swaps - Example
Process of Swap in this case

Company A will borrow at LIBOR + 0.80 and lend to B at LIBOR
.This will help in gain of 0.30 to B ( otherwise B would have directly
borrowed at LIBOR + 0.30) and loss of 0.80 to A ( since A has
borrowed at LIBOR+0.80 and lended at LIBOR)

Company B will borrow at 8.85 and lend to A at 9% . This will help
in saving of 1% to A and gain of 0.15 to B.

Total gain of B = 0.30 + 0.15 = 0.45
Total gain of A = 1.00 0.80 = 0.20

Thus , both the parties have been able to gain due to this
transaction

Interest rate swap
In this swap, Party A agrees to pay Party B a
predetermined, fixed rate of interest on a notional
principal on specific dates for a specified period of time.
Concurrently, Party B agrees to make payments based
on a floating interest rate to Party A on that same
notional principal on the same specified dates for the
same specified time period. In a plain vanilla swap, the
two cash flows are paid in the same currency. The
specified payment dates are called settlement dates,
and the time between are called settlement periods.
Because swaps are customized contracts, interest
payments may be made annually, quarterly, monthly, or
at any other interval determined by the parties.

Interest rate swap Example
For example, on Dec. 31, 2006, Company A and Company B enter
into a five-year swap with the following terms:
Company A pays Company B an amount equal to 6% per annum
on a notional principal of $20 million.
Company B pays Company A an amount equal to one-year LIBOR +
1% per annum on a notional principal of $20 million.
LIBOR, or London Interbank Offer Rate, is the interest rate offered
by London banks on deposits made by other banks in
the eurodollar markets. The market for interest rate swaps
frequently (but not always) uses LIBOR as the base for the floating
rate. For simplicity, let's assume the two parties exchange
payments annually on December 31, beginning in 2007 and
concluding in 2011.
Interest rate swap
At the end of 2007, Company A will pay Company B
$20,000,000 * 6% = $1,200,000. On Dec. 31, 2006, one-year
LIBOR was 5.33%; therefore, Company B will pay Company A
$20,000,000 * (5.33% + 1%) = $1,266,000. In a plain vanilla
interest rate swap, the floating rate is usually determined at
the beginning of the settlement period. Normally, swap
contracts allow for payments to be netted against each other
to avoid unnecessary payments. Here, Company B pays
$66,000, and Company A pays nothing. At no point does the
principal change hands, which is why it is referred to as a
"notional" amount.
Currency swap
The currency swap involves exchanging principal and
fixed interest payments on a loan in one currency for
principal and fixed interest payments on a similar loan in
another currency. Unlike an interest rate swap, the
parties to a currency swap will exchange principal
amounts at the beginning and end of the swap. The two
specified principal amounts are set so as to be
approximately equal to one another, given the exchange
rate at the time the swap is initiated.

Currency swap
For example, Company C, a U.S. firm, and Company D, a
European firm, enter into a five-year currency swap for
$50 million. Let's assume the exchange rate at the time
is $1.25 per euro (e.g. the dollar is worth 0.80 euro).
First, the firms will exchange principals. So, Company C
pays $50 million, and Company D pays 40 million euros.
This satisfies each company's need for funds
denominated in another currency (which is the reason
for the swap).
Currency swap
Then, at intervals specified in the swap agreement, the parties will
exchange interest payments on their respective principal
amounts. To keep things simple, let's say they make these
payments annually, beginning one year from the exchange of
principal. Because Company C has borrowed euros, it must pay
interest in euros based on a euro interest rate. Likewise, Company
D, which borrowed dollars, will pay interest in dollars, based on a
dollar interest rate. For this example, let's say the agreed-upon
dollar-denominated interest rate is 8.25%, and the euro-
denominated interest rate is 3.5%. Thus, each year, Company C
pays 40,000,000 euros * 3.50% = 1,400,000 euros to Company D.
Company D will pay Company C $50,000,000 * 8.25% =
$4,125,000.
Currency swap
As with interest rate swaps, the parties will actually net the
payments against each other at the then-prevailing exchange rate.
If, at the one-year mark, the exchange rate is $1.40 per euro, then
Company C's payment equals $1,960,000, and Company D's
payment would be $4,125,000. In practice, Company D would pay
the net difference of $2,165,000 ($4,125,000 - $1,960,000) to
Company C.
Finally, at the end of the swap (usually also the date of the final
interest payment), the parties re-exchange the original principal
amounts. These principal payments are unaffected by exchange
rates at the time.
Benefits of swap
The motivations for using swap contracts fall into two basic
categories: commercial needs and comparative advantage. The
normal business operations of some firms lead to certain types of
interest rate or currency exposures that swaps can alleviate. For
example, consider a bank, which pays a floating rate of interest on
deposits (e.g. liabilities) and earns a fixed rate of interest on loans
(e.g. assets). This mismatch between assets and liabilities can
cause tremendous difficulties. The bank could use a fixed-pay
swap (pay a fixed rate and receive a floating rate) to convert its
fixed-rate assets into floating-rate assets, which would match up
with its floating rate liabilities.
Benefits of swap
Some companies have a comparative advantage in acquiring
certain types of financing. However, this comparative advantage
may not be for the type of financing desired. In this case, the
company may acquire the financing for which it has a comparative
advantage, then use a swap to get desired form of financing.
For example, consider a well-known U.S. firm that wants to
expand its operations into Europe, where it is less known. It will
likely receive more favorable financing terms in the U.S. By then
using a currency swap, the firm ends with the euros it needs to
fund its expansion.
Exercise
You have been approached by two companies Company A and
Company B for financing arrangement. Company A needs long
term funds whereas Company B needs short term funds. Since,
Company A has low credit rating long term funds are available at
high cost whereas Company B has good crediting rating and have
easy access to long term funds at lower cost but requires short
term funds. The borrowing cost available to them as under:
Fixed Rate (%) Floating Rate (%)
Company A 12 LIBOR + .90
Company B 10 LIBOR + .20
As a Swap dealer, suggest suitable strategy so that the objectives
of both the companies can be fulfilled and their cost of funds is
reduced.