CAPITAL MARKET INSTRUMENTS

The capital markets are relatively for long term (greater than one year  maturity)  financial instruments (e.g. bonds and stocks). It is the largest source of funds with  long  and  indefinite maturity for companies and thereby enhances the capital formation in the country. The following instruments are available for investors in the capital market :-

·         Shares (Equity and preference)

·         Debentures/ Bonds

·         Depository Receipts (ADR’s, GDR’s and IDR’s)

·         Derivatives

The above instruments are discussed as below:

(i)    Shares: Share is a type of security, which signifies ownership in a corporation and represents a claim on the part of the corporation’s assets and earnings. It is a share in the ownership of a company. As one acquires more stock, his or her ownership stake in  the  company  becomes greater.

There are two main types of shares, equity shares and preference shares. Equity share usually entitles the owner to vote at shareholders' meetings and to receive dividends. Preference shares generally do not have voting rights, but have a prior preference on assets and earnings of the company than the equity shares. For example, owners of Preference shares receive dividends before equity shareholders and have priority in the event of a company goes bankrupt or is liquidated.

Basic Features of Shares

Being a shareholder of a public company does not  mean you have a say  in the day-to-day running  of the business. Instead, one vote per share to elect  the board of  directors at  annual meetings is  the extent to which you have a say in the company.

1)         Profits are sometimes paid out in the form of dividends. The more shares you own, the larger  the portion of  the profits you get.  In case of  bankruptcy and liquidation, you'll receive what's  left after all the creditors have been paid.

2)         Another extremely important feature of share is its limited liability, which means that, as an owner of a share, you are not personally liable if the company is not able  to pay  its debts.  Other companies such as partnerships are set up so that if the partnership goes bankrupt the creditors can come after the partners (shareholders) personally and sell off their house, car, furniture, etc.

3)         Companies issue shares to raise capital as it does not require the company to pay back the money after a certain time period (other than redeemable preference shares) or make interest payments continuously. Equity shares can be held by the company till perpetuity.

4)         Equity shares are traded on the cash segment of the capital market. The investors in equity shares make money via dividends or through capital appreciation in the price of the shares. Equity shares are very high risk  instruments with no  guaranteed returns. There is  always a  risk of downside in the value of equity investments.

5)         Shares are traded at market value on stock exchanges. Market Value per share is the current price at which the share is traded. For actively traded stocks (liquid stocks), market price quotations are readily available due to continuous demand and supply for those shares

.However for inactive stocks (illiquid stocks) that have very thin markets, prices  are  very difficult to obtain. Even when obtainable, the information may reflect only the sale of a few shares and not typify the market value of the firm as a whole. Market value per share of an equity share is generally a function of the expectations of the  market  about  the  future earnings of the company and the perceived risk on the part of investors.

(ii)        Preference Shares: These shares form part of the share capital of the company which carry a preferential right to be paid in case a company goes bankrupt or is liquidated. They do not have voting rights but have a higher claim on the assets and earnings of the company. A preference share may also sometimes be convertible partly/fully into equity shares/debentures at a certain ratio during a specified period.

(iii)       Debentures/ Bonds: A bond is a long-term debt security. It represents “debt” in that the bond buyer actually lends the face amount to the bond issuer. The certificate itself is evidence of a lender-creditor relationship. It is a “security” because unlike a car loan or home-improvement loan, the debt can be bought and sold in the open market. In fact a bond is a loan intended to be bought and sold. It is “long-term” by definition; in order to be called a bond. The term must be  longer than five years. Debt securities with maturities under five years are called bills, notes or other terms.  Since bonds are intended to be bought and sold, all the certificates of a bond issue  contain  a  master loan agreement. This agreement between issuer and investor (or  creditor  and  lender), called the ‘bond indenture” or “deed of trust,” contains all the  information  you  would  normally expect to see in any loan agreement, including the following:

         Amount of the Loan: The “face amount” “par value” or “principal” is the amount of the loan - the amount that the bond issuer has agreed to repay at the bond’s maturity.

         Rate of Interest: Bonds are issued with a specified “coupon” or “nominal” rate, which is determined largely by market conditions at the time of the bond’s primary offering. Once determined, it is set contractually for the life of the bond. The amount of the interest payment can be easily calculated by multiplying the rate of interest (or coupon) by the face value of the bond. For instance, a bond with a face amount of ` 1000 and a coupon of 8% pays the bondholder ` 80 a year.

         Schedule or Form of Interest Payments: Interest is paid on most bonds at six-month intervals, usually on either the first or the fifteenth of the month. The ` 80 of annual interest on the bond in the previous example would probably be paid In two installments of ` 40 each.

         Term: A bond’s “maturity,” or the length of time until the principal is repaid varies greatly but is always more than five years. Debt that matures in less than a year is a “money market instrument”

- such as commercial paper or bankers’ acceptances. A “short-term bond,” on the other hand, may have an initial maturity of five years. A “long- term bond” typically matures in 20 to 40 years. The maturity of any bond is predetermined and stated in the trust indenture.

         Call Feature (if any): A “call feature,” if specified in the trust indenture, allows the bond issuer to “call in” the bonds and repay them at a predetermined price before maturity. Bond issuers use this feature to protect themselves from paying more interest than they have to for the money they are borrowing. Companies call in bonds when general interest rates are lower than the coupon rate on the bond, thereby retiring expensive debt and refinancing it at a lower rate.

Suppose IDBI had issued 6 years ` 1000 bonds in 1998 @14% p.a. But now the current interest rate is around 9% to 10%. If the issuer wants to take advantage of the call feature in the bond’s indenture it will call back the earlier issued bonds and reissue them @9% p.a. The sale proceeds of this new issue will be used to pay the old debt. In this way IDBI now enjoys a lower cost for its borrowed money.

Some bonds offer “call protection”; that is, they are guaranteed not to be called for five to ten years. Call features can affect bond values by serving as a ceiling for prices. Investors are generally

unwilling to pay more for a bond than its call price, because they are aware that the bond could be called at a lower call price. If the bond issuer exercises the option to call bonds, the bond holder is usually paid a premium over par for the inconvenience.

•           Refunding: If, when bonds mature, the issuer does not have the cash on hand to repay bondholders; it can issue new bonds and use the proceeds either to redeem the older bonds or to exercise a call option. This process is called refunding.

Yields and its Method of Calculation : There are number of methods for calculating yields. But the most common method is the Yield to Maturity (YTM). Although this is another name of IRR. The formula is as follows:

              Coupon Rate + Redemption Value - Purchase Price

                   YTM =           Period of Holding

                           (Redemption Value + Purchase Value)/2

Determinants of Bond Prices: While Yield To Maturity (YTM) enables traders and investors to compare debt securities with different coupon rates and terms to maturity, it does not determine price. Bond prices depend on a number of factors such as the ability of the issuer to make interest and principal payments and how the bond is collateralized. An across-the-board factor that affects bond prices is the level of prevailing interest rates.

Illustration 1

Suppose a 8% ` 1000 bond had 5 years left to maturity when it was purchased for ` 800. The prevailing interest rate (on other investment vehicles) was about 8%. Further assume that current prevailing interest rates are about 9%. Why should investors buy a five-year old bond yielding 8% when they can buy a newly issued 9% bond?

Solution

The only way the holder of an 8% bond can find a buyer is to sell the bond at a discount, so that its yield to maturity is the same as the coupon rate on new issues. Let’s say interest rates increase from 8% to 10%. With 15 years to maturity, an 8% bond has to be priced so that the discount, when amortized over 15 years has a yield to maturity of 10%. That discount is a little under ` 200:

YTM = Coupon Rate  Pr orated Discount =

(Face Value  Purchase Pr ice) / 2` 80  (` 200/15 years) (`1,000 +` 800)/2= ` 93.33` 900=

10.4%.

The 8% bond with 15 years to maturity must sell at a little over ` 800 to compete with 10% bonds. The possibility that interest rates will cause outstanding bond issues to lose value is called “Interest rate risk.” Yet there is an upside to this risk. If interest rates decline during the five years that the 8% bond is outstanding, the holder could sell it for enough of a premium to make its YTM rate equal to the lower

yields of recent issues. For instance, should Interest rates decline to 7%, the price of the 8% bond with 15 years to maturity will increase by about ` 100.

American Depository Receipt (ADRs): An American Depository Receipt (ADR) is a negotiable receipt which represents one or more depository shares held  by  a  US  custodian bank, which in  turn represent underlying shares of non-US issuer held by  a  custodian in  the home  country. ADR  is an attractive investment to US investors willing to invest in securities of non US issuers for  following reasons:

ADRs provide a means to US investors to trade the non-US company’s shares in US dollars. ADR is a negotiable receipt (which represents the non US share) issued in US capital market and is traded in dollars. The trading in ADR effectively means trading in underlying shares.

ADRs facilitates share transfers. ADRs are negotiable and can be easily transferred among the investors like any other negotiable instrument. The transfer of ADRs automatically transfers the underlying share.

The transfer of ADRs does not involve any stamp duty and hence the transfer of underlying share does not require any stamp duty.

The dividends are paid to the holders of ADRs in U.S. dollars.

A non U.S. issuer has to work with its US investment bankers, US depository bank, US and non US legal counsel and independent accountant to prepare the registration documents and offering materials.

The listing of such an issue is done on the NYSE or AMEX to enable trading. Quotations on NASDAQ can also be used for trading purposes. Any requirement with respect to Blue Sky Law, if not exempted, has to be fulfilled.

Specified document and information must be provided to NASDAQ to enable it to review the terms of the offering and determine whether the underwriting arrangements are fair and reasonable. The filing documents with NASDAQ are the responsibility of managing underwriter.

Global Depository Receipts (GDRs): Global Depository Receipts are negotiable  certificates with publicly traded equity of the issuer as underlying security. An  issue of  depository receipts  would involve the issuer, issuing agent to a foreign depository. The depository, in turn, issues GDR  to investors evidencing their rights as shareholders. Depository  receipts  are  denominated  in  foreign currency and are listed on an international exchange such as London or Luxembourg. GDR enable investors to trade a dollar denominated instrument on an international stock exchange and yet have rights in foreign shares.

The principal purpose of the GDR is to provide international investors with local settlement. The issuer

issuing the shares has to pay dividends to the depository in the domestic currency. The depository has to then convert the domestic currency into dollars for onward payment to receipt holders. GDR bear no risk of capital repayment.

GDR is also issued with warrants attached to them. Warrants give the investors an option to get it converted into equity at a later date. Warrants help the issuer to charge some premium on the GDR sold and it also helps to increase the demand of the GDR issue. The other advantage to the issuer is that it will not have to pay dividends on the warrants till the conversion option is exercised. The disadvantage to the issuer lies in delayed receipt of full proceeds from the issue and in case the conversion option is not exercised the expected proceeds will not be realised.

(vi)       Derivatives: A derivative is a financial instrument which derives its value from some other financial price. This ‘other financial price’ is  called the underlying. The most important derivatives   are futures and options.

These are derivative instruments traded on the stock exchange. The instrument has no independent value, with the same being ‘derived’ from the value of the underlying asset. The asset could be securities, commodities or currencies. Its value varies with the value of the underlying asset. The contract or the lot size is fixed. For example, a Nifty futures contract has 50 stocks.

Futures

This means you agree to buy or sell the underlying security at a 'future' date. If you buy the contract, you promise to pay the price at a specified time. If you sell it, you must transfer it to the buyer at a specified price in the future.

The contract will expire on a pre-specified expiry date (for example, it is the last Thursday of the month for equity futures contracts). Upon expiry, the contract must be settled by delivering the underlying asset or cash. You can also roll over the contract to the next month. If you do not wish to hold it till expiry, you can close it mid-way.

Options

This gives the buyer the right to buy/sell the underlying asset at a predetermined price, within, or at end of a specified period. He is, however, not obliged to do so. The seller of an option is obliged to settle it when the buyer exercises his right.

There are two types of options — call and put. Call is the right but not the obligation to purchase the underlying asset at the specified price by paying a premium. The seller of a call option is obliged to sell the underlying asset at the specified strike price. Put is the right but not the obligation to sell the underlying asset at the specified price by paying a premium. However, the seller is obliged to buy the underlying asset at the specified strike price. Thus, in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller only has the obligation.

Investing in F&O needs less capital as you are required to pay only a margin money (5-20 per cent of the contract) and take a larger exposure. However, it is meant for high networth individuals.

In futures contracts, the buyer and the seller have an unlimited loss or profit potential. The buyer of an option can make unlimited profit and faces limited downside risk. The seller, on the other hand, can make limited profit but faces unlimited downside. (Source: Business Standard)