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, India’s 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 ParticularsDomestic IssuesEuro Issues Pricing of IssuesPricing of the issue is done in advance. Pricing is done on the date of issue. Issue periodThe issue has to remain open for a minimum of three days. No such requirement. Contents of prospectusProjected earnings, appraisal of project from Financial institutions is desirable. Any kind of projections are prohibited. Highlights /risk factorsHighlights and risk factors must be mentioned. Not required. SubscriptionSubscription is required from General public. Can be subscribed only by Qualified Institutional investors.

Difference between Domestic Issues and Euro Issues ParticularsDomestic IssuesEuro Issues Regulatory frameworkThe 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. GovernanceIt is governed by local laws.It is governed by international laws. Name of security holderThe securities are held in the name of the investor. The securities are held in the name of overseas depository. Size of issueNo upper limit to the size of the issue. The amount raised cannot exceed 51% of the capital of company. Terms of paymentThe 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 company’s 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.Eurobond  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 country’s financial market, in the host country’s 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:foreign bond Yankee bondsYankee bonds: dollar-denominated bonds which are issued by non-American borrowers in the U.S. market. Samurai bondsSamurai 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 RateFloating Rate Company A 10.00LIBOR +.80 Company B 8.85 LIBOR +.30 Difference 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 ( ). 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 and lend to B at LIBOR.This will help in gain of 0.30 to B ( otherwise B would have directly borrowed at LIBOR ) 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 = = 0.45  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.fixed rate of interestnotional principalfloating interest ratesettlement dates

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.London Interbank Offer Rateeurodollar

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.comparative advantage

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 12LIBOR +.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.