Tarheel Consultancy Services

Bangalore-India

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International Finance
Part-01
The Financial Ecosystem

2
Categories of Economic Units

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Government Sector

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Government Sector (Cont…)

 Central/Federal government
 State governments
 Local governments a.k.a Municipalities

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Business Sector

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Business Sector (Cont…)

 Sole proprietorships
 Partnerships
 Private Limited Companies
 Public Limited Companies

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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
whole 10

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Financial Claims

funds
SBU DBU
claim

debt instrument

equity shares 11

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Why de we require financial assets?

Properties of
Financial
Assets

Serve as a Promise future They are

store of value returns fungible

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Liability

funds
SBU DBU
claim

ASSET LIABILITY 13

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Liquidity

 What is a liquid asset?

Can be quickly converted to cash with little or
no loss of value
 Why is liquidity important?
Enables transactions at prices that are close to
the fair value of the asset
 Otherwise buyers would have to offers a large
premium
 Sellers would have to offer a large discount

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Liquidity (Cont…)

 In a liquid market plenty of buyers and

sellers will be available
Such markets are said to have Depth
 Attributes of liquid assets
Price stability
Ready marketability
Reversibility

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Liquidity (Cont…)

 There is a cost to liquidity

The more liquid the asset – the lower is the rate
of interest
Interest foregone is lost for ever
 Money is the most perishable of assets

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Illustration of Perishability

 Assume we have 100MM dollars in cash

 If the rate of interest is 3.6% per annum
Income foregone in a week is:
100,000,000x0.036x7/360 = $70,000

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Derivative Securities

 Appropriate term “Derivative Contracts”

Represent a contract between 2 parties

Gives owner certain rights or obligations

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Derivatives…

 “Contracts”  due to an underlying asset /

portfolio of assets
“Underlying asset”  Primary Asset

These contracts are derived from primary

securities  hence the term “Derivatives”

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Introduction (Cont…)

 Underlying asset may be

A stock
A bond
A foreign currency (USD)
A commodity like wheat
A precious metal like gold
A portfolio of assets such as a stock index
(NIFTY, DJIA)

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Categories of derivative securities

Derivative
Securities

Futures &
Options
Forward Swaps
contracts
contracts

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 Cash Transaction vs F&F
Cash transaction F&F
When the deal is struck the The transaction does not
buyer pays for the asset & take place at the outset.
The seller transfers the rights to The 2 parties merely agree
the asset on the terms
The transaction is
scheduled for a future
date
Money changes hands when the No money changes hands.
2 parties enter into the contract Both have an obligation to
perform at the future date

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Illustration

 Mitoken Solutions enters a forward

contract with ICICI Bank:
To acquire $100,000 after 90 days at Rs.
65.50
90 days later:
 Mitoken is obliged to pay Rupees 6.55 MM
 The bank is obliged to deliver $100,000

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Long and Short Positions

 Every Forward/Futures contract has a

Buyer and a Seller.
Long position Short position
The party agreeing to buy the The counterparty
underlying asset is called the agreeing to sell the
LONG underlying asset is called
the SHORT

Said to assume a Long Said to assume a Short

position position. 24

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 Options contracts vs F&F contracts
Options contracts F & F contracts
Options contracts give a Right Futures/Forwards impose
to the buyer an obligation on both
They impose an obligation on parties
the seller

 Option buyers are referred to

as Holders
 Option sellers are referred to
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 Options vs F&F

Right vs Obligation

Right Obligation
A right need be exercised only if
it is in the interest of the holder
A right holder is under no The short has a contingent
compulsion to transact obligation.
If the long exercises, the
short has to perform

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 Calls and Puts
 When a person is given a right with respect to
an asset, it can take on two forms
 Right to Buy
 Right to Sell

Call option Put option

Gives the holder the right to Gives the holder the right to
buy the underlying asset sell the underlying asset

If a holder exercises the If a holder exercises the

writer has to deliver writer has to take delivery

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 European and American Options
European option American option
The right can be exercised The right can be exercised
only on a fixed date in the at any time after it is
future acquired till the
Expiration Date

The expiration date is the only The expiration date is the

point in time at which the last point in time at which
option can be exercised the option can be exercised

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 Option Price vs Exercise Price
Option Price Exercise Price
(option premium) (strike price)
Price paid by the buyer to the Price payable by the
writer for giving him the right buyer if a call is exercised
Price receivable by the

buyer if a put is exercised

It is a sunk cost Enters the picture only if
Non-refundable the holder exercises

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 Option Price vs Exercise Price

Illustration

 Komal goes long in a call on Reliance

X = Rs 900 and 3 months to maturity
Premium = Rs 8.75
 She has to pay Rs 8.75 per share at the outset
The options have been written by Kiran
 If ST > 900 Komal will exercise and buy
Else she will forget the option and buy spot
 At a price which by assumption is lower.

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Example of a Put

 Ross bought a European put on IBM with

X = $85
The premium is $1.10
 He has to pay $110 to the writer
 In the US each contract is for 100 shares
 If ST < $85
It makes sense to exercise and deliver the
shares for $85 each
Else it is better to let it expire
The writer once again has a contingent
obligation. Copyright Tarheel Consultancy Services
Swaps

 Contract between 2 parties to

exchange cash flows
 calculated on the basis of pre-specified
criteria
 calculated at predefined points in time

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Swaps (Cont…)

 Cash flows represent interest payments

on a specified principal
1. One payment may be based on a fixed interest
rate
2. The other may be based on a variable rate
such as LIBOR

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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

underlying asset to deliver the
underlying asset

Put Options Right to sell the Contingent obligation

underlying asset to take delivery of the
underlying asset.

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

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An investor’s concerns

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Returns • Cash
dividends
• Capital
gains/loss
es

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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 < cost Capital loss
 In the 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

• May not
pay
dividends
• Capital
appreciatio
n may be
less/losses
• Firm may
go into
bankruptcy
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Time pattern

• Cash flows
from
bonds are
predictable
• Cash flows
from
dividends
can be
volatile

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A rational investor
H
I
G
H

L
O
W

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Types of Rational Investors
Young investor Retired investor
Are more likely to prefer Usually prefer to invest in
equities. May be content withbonds. For them, the key issue
the possibilities of substantial
is the availability of predictable
capital gains periodic 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
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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.
 Not only should a counterparty be
available, there should be compatibility in
terms of
price and
quantity
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Price Compatibility

 Every trader seeks to trade at a `good’

price.
 What is a good price?
Buyers seek 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 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 50

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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.
These include 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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 Money Mkts. vs. Capital Mkts.
Money Markets Capital Markets
Time to maturity at the time of Markets for medium to long term
issue is one year or less instruments
Money market instruments by Capital market securities include
definition have to be debt both long and medium term debt as
instruments well as equities
Money markets are used to adjust Capital markets channelize funds
temporary liquidity imbalances. In from those who wish to save to
practice, for any company, inflows those who seek to make long term
and outflows at any point in time will productive investments
rarely match
Money markets help firms to Capital markets are where
borrow short term and also to companies source funds for their
deploy surplus funds on a short long term investment needs
term basis
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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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Actors or Players
 Traders in the market can be divided into two
categories.
Those who trade on their Those that arrange trades for
own 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). 59

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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
 How can 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 services of the
 The most important of offered by the exchange
exchange
these services is
traders are traders are
liquidity
those in search those who
 The terms buy side and of liquidity supply liquidity
sell side have nothing traders on both sides regularly
to do with the actual buy as well as sell securities
buying and selling of
securities 63

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 Buy side Sell side
Refers to the portion of Consists of brokers and
the securities business in dealers who help buy side
which primarily traders to trade at their
institutional orders convenience
originate This is selling liquidity
Mutual Funds Investment Bankers
Pension Funds Market Makers
Hedge Funds Specialists
Insurance Companies

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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 may 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
 After a trade has been matched by a
trading system
Post trade processes need to commence
 Clearing
The term refers to all post-trade processes
other than final settlement
Essentially the determination of the obligations
of the counterparties
 Settlement is the final step
Payment of cash to the seller
Transfer of ownership to the buyer 67

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Clearing (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 68

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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.

 There is No Free Lunch

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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 70

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 $/ £

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Equilibrium isServices
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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.

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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
 These deposits 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. 76

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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.

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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.
 The objective is to bolster the safety of the
deposit holders.
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Reserve (Cont…)

 Currently the CRR is 4%

 And the SLR is 20.50%
 SLR has to be held as
Cash
Gold
Unencumbered Securities
 RBI can increase the SLR to up to 40%

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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
 On the 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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Example - Reserves

 Due to high reserve requirements American

banks could not offer attractive rates on
deposits.
 Matters were made 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

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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 loans are not constant, but
loan 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: NOT COMMON

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

Japan:
in Japan:
 Issuer = Japanese
 Issuer = American
company
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 = Japanese  Issuer = American
company company
 Principal = 100 billion  Principal = 100 billion
 Currency of issue = Yen  Currency of issue = Yen
 Currency of Japan = 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

 Spain – Matador

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Masala Bonds

 These are rupee denominated bonds

issued outside India
 Thus they are a type of Eurobond
 The International Finance Corporation
issued bonds worth Rs 1,000 crores to
fund infrastructure projects in India
These were subsequently listed on the London
Stock Exchange (LSE)

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Masala Bonds (Cont…)

 Since the bonds are denominated in

Rupees there is no exchange rate risk for
Indian issuers
 Traditionally Indian issuers have relied on
External Commercial Borrowing (ECBS) to
raise funds

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Masala Bonds (Cont…)
These are loans denominated in convertible
currencies
If the rupee were to depreciate as it has in the
past, it can prove costly for borrowers
The alternative is to hedge away the currency
risk using derivatives, which has its own
associated costs

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Masala Bonds (Cont…)

 Since the bonds are denominated in INR

their sale will lead to an appreciation of the
rupee with respect to foreign currencies
 If the rupee were to appreciate, investors
will stand to benefit at the time of
redemption since they will get more in
dollars
 Indian companies can issue Masala Bonds
with a maximum face value of Rs. 5,000
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Masala Bonds (Cont…)

 To make them more attractive to investors

the minimum maturity of such bonds has
been reduced from five years to three
years.
 There is a 5% withholding tax on interest
payments.

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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
2. 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
4. 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 companies were flocking
Q’, U.S were issuing to these
financial Yankee Yankee
institutions bonds with bonds
could not relatively
offer high attractive
rates of rates of
interest 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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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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Universal Banking – An Indian Illustration

 Take the case of ICICI Bank

It is a traditional commercial bank
 Accepts deposits
 Makes loans
Has an AMC that manages mutual funds
 Collaboration with Prudential PLC
ICICI Prudential is into life insurance
ICICI Lombard is into general insurance
ICICI Home Finance makes real estate loans

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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 as well
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Advantages of Dual Listing

 Foreign listings provide MNCs with indirect

advertising for their product brands
 It raises 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
on international markets Receipts
(DRs)

in the form of Depository

Global American
Depository Depository
Receipts. Receipts
(GDRs)
Receipts
(ADRs)

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What is an ADR?

 A special share of foreign equity priced in USD

 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 119

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
depository will in turn have the and ADRs acquired in lieu
equivalent number of shares sold
in the home market
Less attractive from the Required to ensure that there are
standpoint of an American no arbitrage opportunities
investor between the U.S and the home
market
Has potential to reduce liquidity
and the floating stock of DRs
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Fungibility (Cont…)

 Some years ago we had only one-way

fungibility
ADRs could be converted to Indian shares
But Indian shares could not be converted to
ADRs
Thus there was the spectre of a loss of liquidity
in the US which could only be restored by a
fresh issue of ADRs

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Fungibility (Cont…)

 Two-way fungibility has implications for

liquidity
 It also helps eliminate arbitrage
 Today ADRs which have been converted
to Indian shares can be reconverted to
ADRs.

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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 is like a domestic U.S security
Traded on NYSE, Nasdaq, and OTC markets

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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 can be traded allow issuance
initiated by the on OTC mkts in on U.S. and sale of new
parent foreign the U.S. and on exchanges shares to raise
company some equity capital in
exchanges the U.S.
outside 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 declares dividends in the home currency
 Foreign investors receive dividends in their local
currency

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Benefits to Holders

 Get access to assets which are quoted in

USD and trade like any U.S. security
 Can use a domestic broker and a
domestic depository account
 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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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. Thomson-Reuters and Bloomberg, provide round
the clock access to prices/news from financial centres
across the world
 E.g. Most leading exchanges are now electronic and
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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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