A report on Long term Borrowing in global capital market.
Text of International Finance Management.doc
International Finance Management
Submitted To: - Submitted By:-Prof. M. M. Mehta Girish Harsha
PGDBA- II Roll No. 16
Long Term Borrowing in Global Capital Market
The financial revolution has been characterised by both a tremendous quantitative expansion and an unprecedented qualitative transformation in the instruments and regulatory structures. Global financial markets area relatively a new and recent phenomenon, national market were largely isolated from each other and financial intermediaries in each country operated principally in that country. The foreign exchange market and the Eurocurrency and Eurobond markets based in London were the only markets that were truly global in their operations.
Financial markets everywhere serve to facilitate transfer of resources from surplus units (savers) to deficit units (borrowers), the former attempting to maximize the return on their savings while the latter looking to minimize their borrowing costs. An efficient financial market thus achieves an optimal allocation of surplus funds between alternatives uses; financial markets also offer the savers a wide range of instruments enabling them to diversify their portfolios.
Growing imbalance between savings and investment within individual countries, reflected in their current account balances, has necessitated massive cross-border financial flows i.e. the massive surpluses of the OPEC had to be recycled, fed back into the economies of oil importing nations. The other motive force is the increasing preference on the part of investors for international diversification of their asset portfolios.
Exchange controls, functional and geographical restrictions on financial institutions, restrictions on the kind of securities they can issue and hold in their portfolios, interest rate ceilings and withholding taxes, barriers to foreign entities accessing national markets as borrowers and lenders and to foreign financial intermediaries offering various types of financial services have been already dismantled or are being gradually eased away.
Global Bond Market Fixed rate
o Sold outside borrower’s country and denominated by the currency of the country where issued
o Desire to lower cost of capital
o Underwritten by a bank syndicate and placed in countries other than the one in whose currency the bond is denominated
o Issued by multinational corporations, large domestic corporations, and international institutions
o Not offered in capital market, or to residents, of the country whose currency they are denominated
Eurocurrency MarketThe core of the international money market is Eurocurrency market. A Eurocurrency is time deposits of money in international bank locate in a country different from the country that issued the currency. For example, Eurodollars are deposits of U.S. dollars in banks located outside of United States. Since the dollar deposits outside the U.S. have been called Eurodollars and banks accepting Eurocurrency deposits have been called Eurobanks. The Eurocurrency market is an external banking system that runs parallel to the domestic banking of the country that issued the currency. Both banking systems seek deposits and make loans to customers from the deposited funds. The Eurocurrency market operates at the interbank and wholesale level. The rate charged by banks with excess funds is
referred to as the interbank offered rate; they will accept interbank deposits at the interbank bid rate. The London Interbank Offered Rate (LIBOR) is the reference rate in London for Eurocurrency deposits.
EurocreditsEurocredits are short-to medium-term loans of Eurocurrency extended by Euorbanks to corporations, sovereign governments, nonprime banks, or international organizations. The loans are denominated in currencies other than the home currency of the Eurobank, because these loans are frequently too large for a single bank to handle, Eurobanks will band together to form a bank leading syndicate to share the risk. The credit risk on these loans is greater than on loan to other banks in the interbank market. On Eurocredits originating in London the base lending rate is LIBOR. The lending rate on these credits is stated as LIBOR+X%, where X is lending margin charged depending upon the creditworthiness of the borrower.
EuronotesThese are short-term notes underwritten by a group of international investment or commercial banks called a ‘facility’. A client- borrower makes an agreement with a facility to issue Euronotes in its own name for a period of time, generally 3 to 10 years. These are sold at a discount from face value and pay back the full face value at maturity (3 to 6 months).
Euro-Medium-Term NotesEuro MTNs are fixed-rate notes issued by a corporation with maturities ranging from less than a year to about 10years. It has a fixed maturity and pay coupon interest on periodic dates.
Euro-MTN issue is partially sold on a continuous basis through an issuance facility that allows the borrower to obtain funds only as needed on flexible basis.
Eurocommercial Paper It is like domestic commercial paper, is an unsecured short-term promissory note issued by a corporation or a bank and placed directly with the investment public through a dealer. Maturities range from one to six months.
Global Equity MarketNo equity market in the sense of the international currency and bond markets
o Countries have their own markets to trade corporate stocks.
o Many open to foreign investors
o Internationalization of corporate ownership
o Companies broadening stock ownership by listing stock on foreign exchanges
o Tap into larger pool of funds for investment
o Lowering capital costs
o Facilitate future acquisitions
o Stock and stock options for local employees, suppliers and bankers
o Increasing, firms from developing countries are taking advantage of the opportunity to access these funds
The Major Market SegmentsThe funding avenues potentially open to a borrower in the global capital markets can be categorised as follows
o Straight Bonds
o Floating Rate Notes (FRNs)
o Zero-coupon and deep discount bonds
o Bonds with a variety of option features embedded in them
Bond Marketso A bond is a debt security issued by the borrower,
purchased by the investor, usually through the intermediation of a group of underwriters
o Straight Bond
o It is a debt instrument with a fixed maturity period
o Callable Bond
o It can be redeemed by the issuer, at issuer’s choice
o Puttable bond
o Opposite of callable bond
o It allows the investor to sell it back to the issuer prior to maturity
o Sinking Fund Bond
o Instead of redeeming the entire issue at maturity, the issuer would redeem a fraction of the issue each year so that only a small amount remains to be redeemed at maturity
o The interest rate payable for the next six months is set with reference to a market index such as LIBOR
o Zero Coupon Bond
o Similar to the cumulative deposit schemes
o No interim interest payments
o Convertible Bond
o Can be exchanged for equity shares either of the issuing company or some other company
o An option sold with a bond which gives the holder the right to purchase a financial asset at a stated price
o It may be permanently attached to the bond or detachable and separately tradable
A large number of other variants have been brought to the market
Eurobond Market: Unregistered bearer bonds
Foreign Bonds: Non-resident issues in domestic markets
o Yankee Bonds: Public Issues in the US markets; listed, registered. Strictly regulated.
o Samurai Bonds : Public Issues in the Japanese Market
o Shibosai Bonds, Shogun Bonds and Geisha Bonds (Private placements in the Japanese market)
o Swiss and German Bonds
o Bulldog Bond (Public issues in UK)
o Rembrandt Bonds (Holland)
Syndicated Creditso A traditional Eurosyndicated loan is usually a floating rate
loan with fixed maturity, a fixed drawdown period and a specified repayment schedule
o Lead managers and Agent bank
o A typical Euro credit 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
o Club Loans: Unpublicised, private arrangements
o Standby facility
o 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
o Apart from the Euromarkets, syndicated credits can be arranged in some of the national capital markets too
Medium Term Notes (MTNs)o 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
o The main advantage of borrowing via an MTN or EMTN programme is its flexibility and much less time-consuming formalities of documentation compared to a bond issue
o The market is accessible only to issuers with good credit rating
Medium-term creditThe credits differ as to the form of granting of money: either one-time transfer of money or a revolving credit line. The prevailing method in the credit market is the medium-term credit on a revolving basis at floating interest rate. The rate changes every time the credit is renewed and it is adjusted in accord with the market conditions. For this reason the term of eurocredits granted at a fixed rate (including the revolving credits) usually does not exceed a year. The main principles of international crediting are based on the following: to determine the volumes of prospective credits, to substantiate the purposes which these credits are intended for, to determine the terms of the credits, to determine the risks connected with the credits.
As distinct from the home financial market, the following additional risks exist in the international market:
- Political (specific for a certain country) risk
- exchange risk, (this kind of risk is also present in the national market in case a borrower obtains a credit in a foreign currency)
- Interest risk connected with change in the course of time of the difference between the rates under the credit in the internal and international market.
In order to eliminate the exchange risk, the practice of concluding forward contracts for currency is used in the international market of credits. To decrease the political risks obligatory rules have been laid down for the borrowers who come to the international market, among which is the obtaining an international credit rating. To eliminate the interest risk the revolving credit and stand-by credit contract types are used.
In a case of stand-by a bank binds himself to grant the borrower a stipulated sum for the whole contract term of use, which is divided into short periods (3, 6, 9, 12 months). For each of them a floating interest rate is fixed, which is revised with allowance for LIBOR dynamics in the market of Euro-currencies. This enables to grant medium- and long-term credits, using short-term resources. In case of revolving credit, Eurocredits are
issued on different conditions.
Committed Underwritten FacilitiesThe 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 InstrumentsThese are short-term borrowing instruments and include commercial paper, certificates of deposit and bankers' acceptances among others. In addition to these, export related credit mechanisms such as buyers and suppliers credits, general purpose line of credit, forfeiting are other sources of medium-to-long term funding.
NIF and Related Facilities o Highly rated borrowers decided to short circuit the banks
and raise financing directly from investors by issuing their own paper
o 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
o 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)
Project Financeo 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
o 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
o The lenders may require guarantees
o In some circumstances, third party guarantees can be arranged
o The sources of equity and debt finance for projects have been numerous
o 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)
The International Financing Decisiono 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
o The actual implementation of the selected funding programme involves several other considerations such as satisfying all the regulatory requirements, choosing the right timing and pricing of the issue, effective marketing of the issue and so forth
The critical dimensions of IFD for a firm to chose funding avenues
o Interest rate basis : Mix of fixed rate and floating rate debt
o Maturity : The appropriate maturity composition of debt
o Currency composition of debt
o Which market segments should be tapped
In evaluating a particular borrowing alternative the following parameters have to be examined under alternative scenarios
o The all-in cost of a particular funding instrument
o Interest rate and currency exposure arising from using a particular financing vehicle
o The rate of exchange at time t is denoted St expressed as units of home currency per unit of foreign currency
o 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 - p
o ŝ denotes proportionate change in the spot rate and p is the domestic rate of inflation
The variance of the real cost therefore is o Var(R) = Var(ŝ) + Var (p) - 2Cov (ŝ, p)
o To compare the variances of real costs, the covariance term is important
o Between two currencies, if the variance of both is nearly equal, the one which follow PPP with the home currency more closely will have a lower variance of real cost of borrowing