Depository Receipts

In our last article we tried to give a very clear picture of FCCB, one of the External Commercial Borrowing (ECB) instruments used by the Corporates. Through this article we would like to cover another very important ECB tool which is Depository Receipts.

What is Depository Receipts?

As the name itself suggests it’s a Receipt of Deposit of something and this something in this case is equity shares. A company willing to raise money from Foreign Investors issues such deposits equivalent to the total number of shares deposited with the custodian bank of the country in which the Depository Receipts are to be issued.

The process of issuing of Depository Receipts

Let’s consider a case of a company from India raising money from Russia. After fulfilling certain regulatory requirements, the company can go ahead with the process of the Receipts. For issuing of Depository Receipts the company keeps it certain number of shares with the Indian branch of the Custodian Bank of Russia. After the receipt of the shares the Indian branch confirms it to the Russian Headquarters which then issues the Receipts of Deposits to the company. These are denominated in the Russian Currency (Ruble) and are converted according to the INR to Ruble exchange rate. The Deposit Receipts are issued according to a Depository ratio i.e. each depository specifies the number of shares of the company it represents. Then the company can issue these Receipts in Russia and raise money. After the issuing process is done the Depository Receipts are listed on the stock exchange of Russia and are traded like any other normal share listed on the Exchange.

Some salient features:

· The Depository Receipts holders are not the equity holder for the company.

· The equity holder is the custodian bank of the country and they receive the dividend declared by the company and then they are entitled to distribute it to the Depository Receipts Holder.

· The holders of Depository Receipts don’t have voting rights.

Benefits to the issuing company:

· Very useful instrument to borrow internationally from investors who due to some reason are not able to invest in the Country of the issuing company.

· Gives the issuing company recognition and branding in the country issued and this can be leveraged if the company plans to start its operations in the country.

· Increased prestige in the local market.

Benefits to the Investors in such Receipts:

· There might be a barrier by the Home Country, of the company, which restricts foreign investment. Thus this facilitates them to invest in the companies of such countries.

· This gives them an opportunity to diversify their portfolio internationally and thus reap the benefits of it.

These Depository Receipts have different names which are according to the Country in which they are issued.

· Global Depository Receipts (GDR) or European Depository Receipts (EDR): Depository Receipts issued in European Countries, denominated in Pound or Euro and traded on International Order Book of the London Stock Exchange and other European Exchanges respectively.

· American depository Receipts (ADR): Depository Receipts issued in America, denominated in USD and traded on America’s Stock Exchange

· Chinese Depository Receipts (CDR): Depository Receipts issued in China, denominated in Yuan and traded on China’s Stock Exchange.

· Indian Depository Receipts (IDR): Depository Receipts issued in India, denominated in INR and traded on India’s Stock Exchange

Foreign Currency Convertible Bond

Let us understand each of the above term individually.

A Bond is a debt security, in which the issuer is the borrower and the bond holder is a lender. Depending on the terms of the bond, issuer is obliged to pay interest (the coupon) and repay the principal at a future date called the maturity.

A convertible bond is a bond that can be converted into a predetermined amount of the company’s equity at a certain time during its life, usually at the discretion of the bondholder.
Lets us understand this with a help of an example. Suppose a company ‘A’ issues bonds with following terms –
1. Issue Price of the Bond Rs. 1000
2. Coupon rate 10%
3. Maturity – 2 yrs
4. Convertible into equity shares @ Rs. 800 per share
Now suppose an investor subscribe to 4 such bonds. Thus the total investment required is Rs. 4000. On this investment he is entitled to get an interest @ 10% for 2 years. On the maturity date, i.e. after 2 years, the investor will have an option of either claim full redemption of the amount from the company or get the bonds converted into fully paid equity shares @ Rs. 800 per share. Thus if he goes for the conversion he will be entitled to 5 (4000/800) equity shares. The choice of the investor will depend on the market price of the share on the date of conversion. In the above example if the shares of the company ‘A’ is trading at lower than Rs. 800, say Rs. 500, the investor will be better of by claiming full redemption of his bonds and buying the shares from the market. In this case he will get 8 (4000/500) equity shares as against 5 which he was getting on conversion. Similarly if the market price of the share is higher than Rs. 800, the investor will benefit by getting its shares converted.
Thus from the above we can conclude that on the day of maturity, an investor will seek full redemption if the conversion price is higher than the current market price, and will go for conversion if the conversion price is less than the current market price.
Whatever be the share price on the date of maturity, the investors in such type of bonds does not stand to loose. Their capital stays protected. Thus it’s a win-win situation for the investors.

A Foreign Currency Convertible Bond (FCCB) is a type of convertible bond issued in a currency different than the issuer's domestic currency. In other words, the money being raised by the issuing company is in the form of a foreign currency.

Advantages of FCCB –
Advantage to the investors is clear from the above example. The investors receive the safety of guaranteed payments on the bond and are also able to take advantage of any large price appreciation in the stock.

The issuer company also stands to benefit from the issue of FCCBs-
- Due to the equity side of the bond, which adds value, the coupon payments on the bond are lower for the company, thereby reducing its debt financing costs.
- Saves the risk of immediate equity dilution as in the case of public shares.

Present Day Situation

Indian companies that had raised money through FCCBs during Bull Run to finance their growth and acquisition plans are currently in situation of doom. With demise of Indian stock markets the conversion price of these FCCBs has gone several times higher than their current market price. Various estimates show that India Inc has issued close to $20 billion of FCCBs in the past few years. Now the investor will only exercise its option to convert his bond into fixed number of shares at predetermined price if conversion price is lower than the market price. Now in this scenario of dooming stock markets conversion price in most of the FCCB issues is several times above the market price. For ex. Some companies like JP Associates have a pretty big amount of money out there - JP has $400 million, convertible around Rs. 247. Current price is Rs. 170. Therefore, in such a scenario investors won’t be interested in converting their bonds into equity. The maturity of many FCCBs is expected to start in October 2009 and peak in 2010-2011. Most analysts say the market is unlikely to recover so significantly over the next two years that will match the conversion prices.
In some cases, the outstanding amount on account of FCCBs is higher than or around the current market capitalization of the companies concerned. For instance, Hyderabad-based Subex Auzure raised $180 million (Rs 846 crore) in 2007 to finance the acquisition of Azure. The company’s market capitalization as of September 30 was Rs 298 crore.
Thus at the maturity, the companies that issued FCCBs would be in a difficult situation as they will be burdened with huge debt obligation which will be difficult to meet given the tight liquidity condition.

Securitization of Loans and Mortgage Backed Securitization

The main reason for the Sub Prime Crisis was not bad loans but securitization of these mortgage loans, this process is known as Mortgage Backed Securitization (MBS). This raises the main issue like
· What is Securitization?
· What is Mortgage backed securitization?

Securitization
Thirty years ago, if you got a mortgage from a bank, it was very likely that the bank would keep the loan on its balance sheet until the loan was repaid. That is no longer true. Today, the party that you deal with in order to get the loan amount is highly likely to sell the loan to a third party. The third party often then packages your mortgage with others and sells the payment rights to investors who are willing to invest in such securities. This may not be the final stop for your mortgage. This can continue for additional steps. The process by which most mortgage loans are sold to investors is referred to as Securitization.
In the mortgage market, securitization converts mortgages to Mortgage Backed Securities. Securitization is a process, which involves pooling and repackaging of cash flow producing financial assets into securities that are then sold to investors. It is the process of conversion of existing assets or future cash flows into marketable securities. In other words it deals with conversion of less liquid assets into more liquid ones.
Conversion of existing assets into marketable securities is called Asset Backed Securitization, whereas the conversion of future cash flows into marketable securities is called Future Flows Securitization. Similarly, when the mortgage payments are securitized it is called as Mortgage Backed Securitization. Example of assets that can be securitized is housing loans, car loans, credit card payments etc. Example of future cash flows that can be securitized are car rentals, lease rentals etc.

Mortgage Backed Securitization (MBS)

In layman’s term, Mortgage Backed Securities (MBS) is a mortgage backed/secured by one’s asset wherein one looses the ownership of the asset on default of payment. In the traditional lending process, bank makes a loan, maintaining it as an asset on its balance sheet, collecting principal and interest, and monitoring whether there is any deterioration in borrower’s creditworthiness. This requires banks to hold assets up to the maturity. The funds of the bank are blocked in these loans and to meet its growing fund requirement a bank has to raise additional fund from the market. Securitization is process of freeing up these funds blocked in loans.
To free these blocked funds, the assets are transferred by the originator (the lending bank) to a special purpose vehicles (SPV). The SPV is a separate entity formed exclusively for facilitation of the securitization process and providing funds to the originator. In order to fund the purchase, SPV issues tradable securities to banks, mutual funds, other financial institutions and government. The performance of the securities is then linked to the performance of the assets.
The assets transferred to the SPV need to homogeneous in nature, i.e. only one type of loans (say housing loans) and of similar maturity period (say 20-24 months). These assets are bundled together for creating the securitized instrument. The SPV will act as an intermediary which divides the pooled assets of the originator into marketable securities.
The securities issued by the SPV to the investors are known as pass-through-certificates (PTC). The cash flow received (principal, interests etc) by the originator from the borrowers are passed on to the investors on the pro rata basis. The difference between the rate of interest being charged from the borrowers and the rate of return promised to the investors in PTC is the servicing fees for the SPV.
The originators are generally responsible for collecting the repayments from the borrowers and passing it on to the SPVs.

There are three major risks to MBS investors.

· The first is interest rate risk and it is common to all bondholders. The investors invest in these securities because they carry higher return as compared to other bank deposits. Also, the valuation of these securities is important for the investors as their decision for purchase lies on them. These valuations have an inverse relationship with the interest rate in the market. Higher the interest rate, lower is the value for MBS and vice-versa.
· The second risk is prepayment risk. Many mortgages in the United States can be prepaid without penalty. If they prepay the loan when the interest rate is low, the banks will have to issue fresh loans at the current market rate which would eventually lead to lower return for the IB and thus lower returns to the investors of the securities
· The third risk faced by MBS investors is default risk—that is, the risk that homeowners will default on the mortgages that back the MBS. Private sector MBS issuers may obtain direct insurance against default, but often they structure their MBSs to allocate default brisk toward parties willing to bear it. This risk was overtaken and misjudged in the US’s MBS Market which led to Sub-Prime Crisis.


Re-securitization

Mortgage-backed securities are not the end of the line. Pools of MBSs are sometimes collected and securitized. Bonds that are themselves backed by pools of bonds are referred to as Collateralized Debt Obligations (CDO). The CDOs can look like MBSs, except that the underlying assets are bonds in case of a CDO as against some physical assets in case of MBS. Structured Investment Vehicle (SIV) is similar to CDOs. The difference between SIVs and CDOs is essentially in the type of debt they issue. The SIVs are structures backed by pools of assets, such as MBSs and CDO bonds. The SIVs issue short- and medium-term debt rather than the longer-term debt of most CDOs. The short-term debt is referred to as asset-backed commercial paper.

Rupee Depreciation

Currency depreciation is defined as a decrease in the value of one currency relative to another currency, i.e. because of change in exchange rates, unit of one currency buys less units of another currency.

 

The value of a currency can be maintained by the Central Bank of the Country in the following three manners:

 

• Free Floating: The value of one currency to another is determined by the supply and demand for that currency
• Partly Fixed: The rates are determined by the Supply and demand of the currency but the Central Bank of that country interferes through open market operations and thus controls the currency value. India’s Currency Management system is partly fixed.
• Fixed: The value of the Currency is kept fixed as compared to the other currencies. China’s currency is fixed.

 

Rupee Depreciating is Indian Rupee depreciating against dollar; it means that a unit of rupee will buy less units of dollar or that more units of rupee will be required to buy one unit of dollar.

 

Let us understand the dynamics of the currency movement. Just like any other commodity, the upward/downward movement of the value of a currency is based on the dynamics of demand and supply. As the demand for rupee increases, its value rises and vice versa. Thus if the rupee has depreciated against dollar, it means that the demand for dollar and supply of rupee is rising.

 

But there is a significant role of the RBI in this process. Since India’s currency is partly fixed so the Central Bank through its open market selling and purchasing of Rupee tries to fill the supply demand gap and thus control the value of the currency.

 

Now when we say that rupee is depreciating against dollar, it would mean that the demand for dollar is rising and there is a selling pressure on rupee. Now from where do the above arise?

 

Imports – If a person in India imports goods/services from a foreign country, he/she will have to make payment in the currency of that country. Now to acquire that currency, he/she will have to sell Indian Rupee to the banks. Thus in the process creating a demand for foreign currency against the Indian rupee

 

Investments abroad – If a person in India plans to invest abroad, he will have to acquire foreign currency by selling the home currency.

 

Repayment of loan – If a corporate had taken an overseas loan, the repayment is done in the lender’s currency. Thus at the time of repayment, corporate will have to acquire foreign currency.

 

Disinvestment by FIIs – When foreign investors liquidate their investments in Indian market, they sell rupee and buy foreign currency in order to repatriate the funds to their home currency. Earlier when Indian economy and Indian stock market was on a roll, strong capital inflows from FIIs had led to the rupee appreciation. Now, when the market is at its all time low, there is continuous withdrawal of capital by the FIIs from the market which has primarily led to this rupee depreciation.

 

Similarly, any activity that requires outflow of funds from the home country will create a demand for the foreign currency and hence would lead to rupee depreciation. Similarly, any activity that would require inflow of funds to the country, it will create a demand for the home currency and lead to rupee appreciation.

 

Having understood the reason for rupee depreciation we must understand its implications. Ask any patriotic enthusiast whether rupee depreciation is good for economy or bad for economy and probably his reply would be “Obviously bad for our economy….we are losing the battle to the green buck….”

 

Well let us understand its implication from a broader perspective.

 

Positive Implications of Rupee Depreciation:

 

1)      Higher revenue for exporters – Exporters earn their income in dollars which is spent in rupees back home for further investment or consumption. If the rupee depreciates, their earnings in rupee terms will rise.

To explain it better, say that exchange rate is USD 1 = 50 INR. If an exporter earns USD 1000, his earning in rupee terms is 50000 INR. If the rupee depreciates to USD 1 = 60 INR, then in rupee terms the earnings of exporter will be 60000 INR. A rise in earnings, despite the revenue in dollar remaining constant.

2)      IT Industry – IT industry has been a major contributor to exports. IT companies have more than 60% of their revenues from US. It is said that for 1% depreciation in INR, their earnings rise by 30 basis points. Other export oriented industries in India will benefit from the depreciating rupee.

3)      Repatriated profits – Remittances to India by NRIs - Rapid currency depreciation increases the value of repatriated profits.

4)      Tourism – India is now a cheaper place to visit.

5)      More foreign investments – increase in FDI/FIIs

 

Negative implications of Rupee Depreciation:

 

1) Importers – The importers of goods and technologies are the worst hit. The value payable in the Exporting country’s currency remains the same but the value payable in the Indian Rupee terms increases by a considerable amount.

2)OIL and OMC - Although crude price might have corrected by around 57 per cent in dollar terms, it has contracted by 52.5 per cent in real terms due to the nine per cent rupee depreciation in the last four months. "The crude's cut-off was around $67-68 per barrel when the rupee was trading at Rs 41-42 levels. But, on account of rupee depreciating to levels of Rs 49, recently, the cut-off has been revised to $59/barrel." Thus, the OMCs would make meaningful profits on their direct sales of petroleum products, if the crude prices sustain below break-even rates for a reasonable amount of time.

3) Corporate borrowings – The borrowing rates of Corporate (in case of borrowing from an International Lender) increases as they are supposed to repay more (both as principal and Interest) in Rupee terms in case of the rupee depreciation, since the amount payable is in the lending Country’s currency.

4) Mergers & Acquisition – In the event of an overseas acquisition by an Indian company, the Indian Company has to pay more and thus the returns of the Indian Company go down.

 

 

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SeNSeX DeMyStiFiED

Everyone has heard of the Sensex. Most of us know it is the index of the Bombay Stock Exchange. But there are lots of facts you are probably unaware of. Here are some interesting facts about the Sensex.

1. The Sensex is made up of only 30 stocks: These stocks represent around a dozen sectors. They are leaders in their respective industries.

2. The stocks are picked by the stock selection committee (known as the Index Committee).

There are certain basic parameters fixed when picking these 30 stocks. They are:

·         The stock should have been listed and traded on each and every trading day for the past one year.

·         It should be among the top 150 companies listed by

-       average number of trades (buying or selling of shares) and

-       the average value of the trades per day over the past one year.

The list of companies included in the Sensex is not permanent and the list is revised continuously based on the above criteria. For eg. Tata Power Co. ltd replaced Cipla ltd. on 28^th Aug 2008.

3. The job of the Sensex is to capture the price movement of the equity market.

The Sensex reflects the price movements of shares. If the Sensex rises, it indicates the market is doing well.

The price of every stock price rises or falls for two possible reasons:

News about the company

Great earnings, great annual or quarterly results, product launch, closure of a factory, the government providing tax or duty exemptions to the sector so more profits expected, a feud among the company's top bosses, etc. This is called stock specific news.

News about the country

Testing a nuclear bomb, a terrorist attack, the Budget announcement, new tax regime, declaration of war, change of government, good monsoons and hence a good agricultural crop, etc. This is called index news.

Global Cues

Movement of other stock exchanges world wide, U.S. sub prime crisis, bankruptcy of Lehman Brothers etc.

The job of an index is mainly to capture the news about the country. This will reflect the movement of the stock market as a whole. It could also reflect the sentiment of the market as a whole. If corporate India is largely doing well, then it will get reflected here.

4. How is Sensex Calculated?

Each of the 30 stocks in the Sensex has a weight attached to it. This weight depends on the market capitalisation of the stock.

There are two methods to calculate the market capitalisation:

Full Market Capitalisation Method

Full market capitalisation refers to the total number of shares of a company is multiplied by the market price.

Free-float weightage

In case of free float weightage only the shares that are available for trading (some of the shares issued to the promoters or government are not allowed to be traded) is multiplied by the market price.

Let us take an example:

Assume a company X with following share holding pattern

Shares Held by	No. of Shares	% of holding
Promoters	200000	50.00%
Institutional Investors	100000	25.00%
General Public	100000	25.00%
TOTAL	400000	1

 

Assuming the Market Price per share is Rs. 20

 

Under Full Capitalisation Method

 

Total Market Capitalisation = Rs. 400000 x 20

                                                   = Rs.8000000

 

Under Free Float Weightage Method

 

Total Market Capitalisation = Rs. 200000 x 20

                                                   = Rs.4000000

 

Note: 200000 shares held by promoters is not taken into account

 

This calculation is done every 15 seconds in a trading day

 

 The Sensex uses the free-float weightage method whereas S&P CNX NIFTY uses Full Capitalisation Method

Till 1^st September 2003 the value of Sensex was also computed on the basis of Full Capitalisation method