List of financial instruments: 1. Equity 2. Fixed Income Securities 3. Derivative Securities 4. Structured Finance Securities 5. Participating Notes.
Though equity shares are usually associated with voting rights, some may have no voting rights. Others may have more than one vote per share—shares with differential voting rights (DVRs). American Depository Receipts (ADRs), Global Depository Receipts (GDRs) and Indian Depository Receipts (IDRs) allow investors to trade equity shares of a foreign company. An IDR is a depository receipt listed and traded on stock exchanges in India. It is issued by a foreign company in India, giving Indian investors ownership rights. The foreign issuer need not pay divide in India on dividend paid to IDR holders.
2. Fixed Income Securities:
Fixed income securities consist of corporate bonds (short term, medium term and long term), municipal bonds, and sovereign bonds (short term, medium term, and long term). Treasury Bills are short-term bonds issued by the central government. Fixed income securities may be redeemable or irredeemable, convertible or non-convertible, issued domestically and denominated in domestic currency, or issued overseas, and denominated in foreign currency.
They may carry a fixed rate of interest (fixed coupon bonds), no rate (zero coupon bonds), or a variable rate of interest (floating rate bonds). The latter are usually linked to the interest rate at which banks offer to lend money to each other for one month, three months, and six months in the inter-bank market. Called the inter-bank offer rate, it is the weighted average of rates quoted in the inter-bank market at a particular time on every business day. Each financial centre has a different inter-bank offer rate.
Depending on the location in which money is lent, the IBOR is given an alphabet as a prefix:
i. LIBOR (London Inter-Bank Offer Rate) is the rate at which funds are borrowed and lent by banks in London’s call money market. Each day, the LIBOR is calculated at 11 am using rates quoted by 8 British banks.
ii. SIBOR (Singapore Inter-Bank Offer Rate) is the rate at which funds are borrowed and lent by banks in Singapore’s call money market.
iii. EURIBOR is the European Inter-Bank Offer Rate. It is the rate at which prime banks lend to other banks in the euro-zone financial centres for 1- to 12-month deposits in domestic euros. It is calculated by the European Banking Federation using rates from 57 prime banks. The EURIBOR replaced the inter-bank offer rates of Frankfurt (FIBOR), Madrid, Milan(each known as MIBOR) and Paris (PIBOR).
iv. MIBOR (Mumbai Inter-Bank Offer Rate) is the rate at which funds are borrowed and lent by banks in Mumbai. MIBOR rates are calculated by the, The National Stock Exchange (NSE) and Bloomberg. The NSE collects rates from 33 banks and primary dealers and calculates the MIBOR using the bootstrapping method. These are rates at which they would lend Rs. 500 million in the overnight money market
v. CCIL-MIBOR is a collateralized benchmark reference rate based upon orders placed in the collateralized borrowing and lending (CBLO) market. It is provided by the Clearing Corporation of India Ltd (CCIL), which began disseminating the rate in 2006.
An IDR holder has the right to:
ii. Receive dividend
iii. Bonus issues
iv. Participate in a rights issue
vi. View the issuer company’s annual reports
vii. Participate in subdivision and consolidation of underlying equity shares
viii. Approach the registrar of IDR issue with respect to queries and problems in the IDR issue
3. Derivative Securities:
Financial derivatives are derived from primary securities. Derivatives can be classified as commodity, equity and currency derivatives, or as financial (currency derivatives) and non- financial derivatives (commodity, stock and stock index derivatives). The underlying asset in an equity derivative (or stock) is stock, and a stock index in an index derivative (such as the S&P 500 or the NSE Nifty). Stock derivatives include equity swaps, equity options and equity forwards.
The underlying asset in a commodity derivative is a commodity (such as gold, silver, copper rubber, tin, and oil). The underlying asset in an interest rate derivative is an interest rate.
A currency is the underlying asset in a currency derivative. Currency derivatives—currency futures and options—are traded on three exchanges in India—the NSE, BSE and the United Stock exchange (USE). The USE is India’s youngest exchange and is dedicated to currency derivatives. It commenced trading operations in September 2010.
4. Structured Finance Securities:
The term ‘structured finance’ refers to any financial arrangement that hedges and/or refinances an activity in ways not possible with traditional financial instruments. All structured finance products are derivatives and have pre-determined pay off structures.
The subprime crisis of 2007 brought structured finance products to the forefront. They were traded in the OTC market by some of the biggest names in global financial markets— Nomura Securities, Lehman Brothers, Bear Sterns, Goldman Sachs, Merrill Lynch, Morgan Stanley, AIG, Citigroup, UBS, BNP Paribas, HSBC, ING and Barclays, to name a few.
Structured finance products were held responsible for the global recession that followed the crisis. Billions of dollars of mortgage backed securities (MBSs), commercial mortgage backed securities (CMBSs), collateralized debt obligations (CDOs), collateralized bond obligations (CBOs), and credit default swaps (CDSs) were issued by investment banks, insurance companies, commercial banks and housing finance companies in the USA.
As defined by the Committee on Global Financial System, structured finance comprises of asset pools, liabilities backed by asset pools and the use of a special purpose vehicle (SPV) to disassociate the asset pool’s credit risk from the credit risk of the securitized products created from the asset pool.
Structured finance products can be broadly classified as discussed below:
A. Securitization Products:
Securitization is a process by which an asset (the loan book of a housing finance company or a commercial bank, the receivables of a manufacturing company, the fixed income investment portfolio of any entity) is converted into financial securities— usually fixed income securities. The assets are sold to an SPV which in turn issues securities (called pass through certificates) against the asset pool that it has purchased.
If it has bought five-year loans from a bank, it can slice them into tranches and issue securities with maturities of one year to five years respectively, each bearing a different interest rate. SPVs procure a credit rating for these securities. Mono-line insurance companies in USA—such as the Municipal Bond Insurance Association (MBIA) and AMBAC—provide financial guarantee insurance to the securities. Securities issued by the SPV are called asset backed securities (ABSs). They have maturities (tenors) ranging from 3 to 15 years. ABSs are assigned a prefix that describes the asset pool against which they were issued.
i. Mortgage Backed Securities (MBSs):
They are issued against an asset pool of mortgages. If the pool consists of loans made for commercial property, the securities are called commercial mortgage backed securities (CMBSs). If the pool consists of loans made for residential property by individual house owners, the securities are called residential mortgage backed securities (RMBSs).
ii. Collateralized Loan Obligations (CLOs):
They are securities issued against an asset pool of loans (housing loans and non-housing loans).
iii. Collateralized Bond Obligations (CBOs):
They are securities issued against an asset pool comprising of sovereign bonds, corporate bonds (spanning the rating spectrum from investment grade to junk), or a mix of both.
iv. Collateralized Debt Obligations (CDOs):
They are securities issued against an asset pool comprising of non-housing loans and bonds (corporate and/or sovereign). Bonds (irrespective of credit rating), loans (irrespective of credit risk) and insurance receivables were securitized to create CDOs in USA. CDOs have recorded the fastest growth among structured finance products. Cash flow CDOs use the cash generated from interest payments and principal repayments to meet scheduled payments. Synthetic CDOs are leveraged investments which replicate the funding of a cash flow CDO.
Market value CDOs are issued against an asset pool consisting of cash, commercial paper, loans, bonds, and equity. The asset pool is dynamically managed and its market value is measured frequently. Therefore, the composition of the asset pool changes throughout the CDOs’ tenor, because the manager of the CDOs is looking for market appreciation. High-yield CDOs are backed by a pool of high yielding corporate bonds, but the CDOs themselves carry an investment grade credit rating.
v. Collateralized Automobile Receivables Securities (CARS):
As the name implies, the securities are issued against an asset pool comprising of receivables purchased from automobile companies.
vi. ABSs are often privately placed and purchased by institutional investors (banks, insurance companies, mutual funds).
The advantages to the asset pool originator (the housing finance company, the commercial bank or the manufacturing company, as the case maybe) are:
a. The asset pool originator converts an illiquid asset into cash and reconfigures its balance sheet.
b. The loan originator (such as the housing finance company) no longer owns the asset (loan) and the consequent risks associated with default. If the borrower does not repay the loan, the loan originator is unconcerned, since it no longer bears the borrower’s credit risk.
c. The loan originator is not exposed to the risk that interest rates may vary over the term of the loan (interest rate risk).
d. The cash received is recycled (by making more loans in the case of a bank or mortgage finance company) so that the volume of business increases.
Through securitization, the ‘originate and keep’ model of housing finance companies and banks gets replaced by the ‘originate and distribute’ model. Securitization re-distributes interest rate risk and credit risk to a broader range of investors and diffuses risk across the capital market.
They provide credit protection against a pre-defined event. Credit Default Swaps (CDSs) and Total Return Swaps (TRSs) are the two types of credit derivatives. The CDS transfers default risk from-(the buyer) to (the seller) who assumes the credit risk. The seller may be a hedge fund or an investment bank. The buyer pays a premium to the seller. When a credit event occurs (for example, a default or bankruptcy) the buyer receives a pre-specified lump sum from the seller and hands over the least priced assets (on which the credit risk was covered) in return. The first CDS was issued in 1995.
A TRS is also known as a Total Rate of Return Swap (TORS). The buyer of a TRS exchanges the total return on an asset (or a group of assets) for promised, pre-specified and periodic cash flows to be paid by the seller.
B. Hybrid Products:
A hybrid includes ‘regular’ hybrids such as synthetic CDOs and credit linked notes (CLNs) and indexed hybrids such as CDS of ABS.
i. Synthetic CDO:
It is a security backed by a pool of credit default swaps. Suppose a commercial bank has a loan book of Rs. 500 crores. Instead of selling the loans to an SPV, it pays the SPV a periodic amount (the premium). If the borrowers do not repay their loans, the bank will collect the loan amount from the SPV. This is nothing but a credit default swap (CDS). The SPV sells securities—called synthetic CDOs— to institutional investors. The SPV invests the amount received from the investors in assets with a high credit quality. It pays the holders of synthetic CDOs a periodic interest from the returns it gets from the assets and the premium collected from the bank.
ii. Credit Linked Note (CLN):
It is a structured product in which payment is linked to a company’s creditworthiness. CLNs are issued by an SPV to institutional investors who want to hold bonds of a creditworthy company. The SPV invests the amount received from the investors in high credit quality assets (such as sovereign bonds) and promises to pay the institutional investors’ interest on the CLNs.
The SPV pays a periodic amount (the premium) to another entity in return for protection against default—that is the SPV buys a CDS. On maturity of the CLNs, the investors receive their principal. But if the SPV defaults on maturity, the investors receive nothing. Lehman Brothers sold billions of dollars of CLNs. When Lehman collapsed, the CLN holders got nothing, and the CLN values plummeted.
iii. CDS of ABS:
It is a credit default swap that is based upon an asset backed security (such as an MBS). The buyer of the CDS of ABS pays an amount (the premium) to the seller in return for protection from a shortfall of cash flow on the ABS, throughout the entire life of the ABS. It is also called a pay-as-you-go (PAUG).
5. Participating Notes:
When a country’s financial system (as in China and India) restricts access to overseas investors, new instruments—such as participatory notes (PNs)—emerge to feed their demand. Participatory Notes (PNs) are securities issued overseas by associates of foreign brokerages that operate in India. Each PN has an underlying number of equity shares and its value depends on the value of the equity shares. Therefore, the PN is a derivative.
PNs are written offshore and purchased by offshore investors (such as hedge funds) that do not want to meet the disclosure and reporting norms mandated by the domestic regulator. They are traded offshore and are freely transferable.
In an open financial system, financial securities can be bought by overseas investors. When holdings by overseas investors are sought to be regulated, the trading merely moves overseas—PNs are a classic example. PNs traded overseas are beyond SEBI’s jurisdiction, underscoring the difficulty of regulating financial markets.