Understanding Bonds, Hybrid Securities, Commercial And Investment Banks: A Finance Overview

Retaining earnings: Issuing bonds allows company to access capital much faster than if it had to earn and save profits.

1. Benefits and disadvantages of bonds and shares:
2. Benefits and disadvantages of bonds

Retaining earnings: Issuing bonds allows company to access capital much faster than if it had to earn and save profits.

Selling Assets: To access more capital, the company may need to sell some of its existing assets which may not have much market value as compared to asset cost. This makes selling assets more costly for the company. Thus, by issuing bonds, the company can have more capital and use their existing assets for business resulting into more productivity.

Tax Benefits: Issuing bonds offers tax benefit. Law of many countries give tax deduction on investing in several type of bonds (Mariani & Amoruso, 2016).

• Risky: Borrowing money is always risky as compared to issuing shares. If Company’s fortunes change and it has no money to pay off its creditors, the company still have to somehow pay its bondholders their principal amount (Harold, 2015).
• Interest payment: When any company issues shares, it declares dividends in case of profit situation only. Such is not the case in case if bonds. The company has to pay interest in any situation. Whether it is loss or profit (Umstot, 2014).
• Increased Capital and Less Debt: Same as bonds, the company gets to use more capital for its business for earning increased profits. Also, debt of the company does not increase by issuing shares (Bornmann, 2014).
• Division of profits and loss of control: By issuing shares the company general public to become owners of the company. Due to this, the profits of the company are distributed in more number of individuals and also the control is lost from few number of owners (Saunders & Cornett, 2014)..
• Similarities between preference shares and convertible bonds and reason why they are called hybrid:
• Fixed rate of return: Both preference shares and bonds offer fixed rate of return. Difference is only that return from preference shares is called dividend and return from bonds is called interest (Andrew, 2017).
• No rights in ownership and management: Both preference shareholders and bondholders don’t get rights in ownership and management of the company.
• Preference: Both bonds and preference shareholders are given preference over equity shareholders in relation of any kind of payment, whether it is dividend/interest or principal value of instrument (Grundy & Verwijmeren, 2016).

• Definition of hybrid financial instruments: Financial instrument having characteristics of two or more financial instruments are referred to as “hybrid” instruments, generally combine both debt and equity characters.
• In case of both convertible bonds and preference shares, they contain characteristic of both equity and debts. Bonds are debt of the company but can be converted into equity and also preference shares contains both characteristics i.e. debt and equity. Hence, both are called “hybrid” instruments (De Spiegeleer, Schoutens & Van Hulle, 2014).
• Due to rise interest rates, most important impact will be rise in interest cost to company. This will impact on profits of the company and ultimately on shareholders return.
• Another Impact will be company will try to not raise funds through bonds as interest rates are high and this will result in less use of bonds as a financial instrument (Campbell, Pflueger & Viceira, 2014).

• As the rate of interest has been increased, shareholders will expect more rate of dividend on shares. In case their expectations are not fulfilled, it may impact in less investment in market in form of equity.
• Due to increased borrowing costs shareholders may not borrow such funds from market to invest in equity that they should have borrowed at less interest rate (Zerodha, 2015).

Commercial Bank

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·               Commercial Banks manage funds of public in general. They manage deposits, borrowings, business accounts and make funds available to general public businesses through deposits made with them. ·               Commercial banks are regulated by apex banks of respective countries. For example, ‘Reserve bank of India’ in case of Indian Commercial Banks. ·               Major source of income is interest from customers.

·            Investment Banks expedite the purchase and sales of bonds, debentures, stock and other investments and help companies in initial public offerings. ·            Investment Banks are regulated by Securities and Exchange Commission of respective countries. For example in case of India, investment banks are regulated by Securities and Exchange Board of India. ·            Major source of income is commission from investors (Ongore & Kusa, 2013).

UOB

Morgan Stanley, UK

·               Major source of income in case of UOB is interest income from customers. ·               Other income consists of fees and commission. Further, commercial banks also earn rental incomes. ·               Major expense in case of OUB is employee cost and interest expenses as well (Kraft, 2014). ·               Current assets include investment properties, financial instruments kept as lien. Government treasury bills and securities, loans to customers, trading securities kept as lien, cash and bank balances, etc. Thus, assessing the differences, commercial banks cannot have trade receivables, as the amount given by commercial banks to its customers is termed as loan to customers not as trade receivable. ·               Same is the case with current liabilities. Commercial banks cannot have trade payables as part of its current liabilities.

·        Major source of income is financial instruments which are held for trading ·        Other income consists of Interest. There cannot be rental incomes in investment banks. ·        Employee cost is only major expenses in income statement of Morgan Stanley, UK. ·        Current assets include cash and short term deposits, cash collateral on securities borrowed, securities purchased under agreement to resale, Trade receivables, etc. Thus assessing the differences, investment banks cannot have any securities kept as lien or guarantee as this is the function of commercial bank. ·        Investment banks cannot have bills receivable or payable as part of their current liabilities as discounting bills is not part of their business functions (Ball & Shivakumar, 2015).

1. Calculation of interest payable to DBS
2. Calculation of rate of interest:-

Interest= Libor rate + Base points

= .75+200(bps)

= 2.75 %

1. Interest = 10,000,000 USD * 2.75 %

= 275,000 USD  

1. Analysis of risks that the loan exposes Bright fortune to:
2. Change in Libor rate: As the interest is based on Libor rate plus base points, change in Libor rate will result in increase interest cost.
3. Change in Forex rates: As the company is based in Singapore but operates in USD as functional currency and the loan is in USD, change in rates of Singapore Dollars vis a vis USD may result in losses to the company. This will majorly depend upon economic stability of country of which currency is being used as functional currency.
4. Risk of Non payment: In case of losses the Company may not be able to repay principal amount of loan on scheduled repayment period. This may result into decreased credibility, risk of bankruptcy and risk of damage to goodwill.

1. Hedging of interest: Interest rate swaps typically involve trading of a variable rate loan structure for one with a fixed rate or vice versa. In this case, Bright Fortune Ltd is paying variable interest rate @ Libor rate plus 200 base points.

To hedge this risk of variable interest rates which will mainly depend upon change in USD rates, Bright Fortunes should enter into a hedging contract with fixed interest rates. For this, company has to premium which will depend upon individual contracts which should be maximum 1.5% .

This premium will be amortized over the loan term equally, but risk of currency fluctuation will be eliminated (Buraschi & Whelan, 2016).

1. Hedging of principal amount of loan: As compared to interest, principal repayment

Will posses less risk as interest portion contains risks of currency fluctuation and Libor rate fluctuation as well, but principal value possesses risk of currency fluctuation only (Cheng, Sklibosios Nikitopoulos & Schlogl, 2016).

To deal with this risk, the company should hedge its principal value with swap currency as USD as the repayment is in USD only. Due to this the loss on change in foreign currency will get eliminated at the cost of very nominal premium amount on hedging contract with third party (Hollingsworth & Trussel, 2017).

1. Risk for Oazwood in this transaction-

Oazwood dealing in Australia has to issue invoice in Japanese currency. But it may happen that at the time of settlement of transaction there is change in value of Japanese yen as compared to date when Oazwood entered into the transaction.

This may result in forex gain/losses to Oazwood.

For example, currency rate on date of transaction 100 Yen/AUD, and on settlement, the rate changes to 102 YEN/AUD, then Oazwood will have gains in foreign currency (Natenberg, 2014).

1. Best option and best forward transaction:
2. Best Option: Oawood should not take any call for increase in rate of Japanese YEN/AUD, as if the rate increases Oazwood will enjoy forex gains, so there is no risk to be hedged in case expectation is rate of YEN will increase.

Hence, Oazwood should take Put call on strike price on 99. At this strike price, it has to pay premium of 3.8 but risk of currency fluctuation will be eliminated, at this premium amount.

1. Best Forward Contract:

Oaazwood has to hedge the risk for 3 months as the transaction will get settled in 3 months. Hedging for 1 or 2 months is not a good option has still risk of foreign currency fluctuation will remain as it is for balance un hedged period.

So, Oazwood should take hedging contract for 3 months at a forward rate 99.78(ask), for which it has to pay premium of 0.22(100-98), but risk will be hedged for entire 3 months (Safdarian, Fotuhi-Firuzabad & Lehtonen, 2014)Solution:

					(Amount in Millions)
Hedge Transaction	Do nothing		Forward		Option
Spot AUD/JPY	Formula for Net Aud Proceeds	Net Aud Proceeds	Formula for Net AUD Proceeds	Net Aud Proceeds	Formula for Net Aud Proceeds	Net Aud Proceeds
98	Total AUD * 98	338.10	Total AUD * 98.78	340.79	Total AUD * 100	345.00
100	Total AUD * 100	345.00	Total AUD * 98.78	340.79	Total AUD * 100	345.00
103	Total AUD * 103	355.35	Total AUD * 98.78	340.79	Total AUD * 103	355.35

References:

Andrew B. (2017), Hedging Basics, Hedging Basics: What is Hedge,4,

Ball, R., Li, X., & Shivakumar, L. (2015). Contractibility and transparency of financial statement information prepared under IFRS: Evidence from debt contracts around IFRS adoption. Journal of Accounting Research, 53(5), 915-963.

Bornmann, L. (2014). Do altmetrics point to the broader impact of research? An overview of benefits and disadvantages of altmetrics. Journal of informetrics, 8(4), 895-903.

Buraschi, A., & Whelan, P. (2016). Speculation, Hedging, and Interest Rates.

Campbell, J. Y., Pflueger, C., & Viceira, L. M. (2014). Monetary policy drivers of bond and equity risks (No. w20070). National Bureau of Economic Research.

Cheng, B., Sklibosios Nikitopoulos, C., & Schlogl, E. (2016). Hedging futures options with stochastic interest rates.

De Spiegeleer, J., Schoutens, W., & Van Hulle, C. (2014). The Handbook of Hybrid Securities: convertible bonds, coco bonds and bail-in. John Wiley & Sons.

Grundy, B. D., & Verwijmeren, P. (2016). Disappearing Call Delay and Dividend?Protected Convertible Bonds. The Journal of Finance, 71(1), 195-224.

Harold A.(2015), Advantages of Bonds over Stock, Bonds as type of raising capital, 1, Retrieved from https://www.accountingcoach.com/blog/bonds-instead-of-stock

Hollingsworth, D. P., & Trussel, J. M. (2017). Accounting for Private Company Interest Rate Swaps: An Overview With Planning Strategies. Journal of Corporate Accounting & Finance, 28(3), 10-17.

Kraft, P. (2014). Rating agency adjustments to GAAP financial statements and their effect on ratings and credit spreads. The Accounting Review, 90(2), 641-674.

Mariani, M., & Amoruso, P. (2016). The Effectiveness of Catastrophe Bonds in Portfolio Diversification. International Journal of Economics and Financial Issues, 6(4).

Natenberg, S. (2014). Option volatility and pricing: Advanced trading strategies and techniques. McGraw Hill Professional.

Ongore, V. O., & Kusa, G. B. (2013). Determinants of financial performance of commercial banks in Kenya. International Journal of Economics and Financial Issues, 3(1), 237.

Safdarian, A., Fotuhi-Firuzabad, M., & Lehtonen, M. (2014). Impacts of time-varying electricity rates on forward contract scheduling of DisCos. IEEE Transactions on Power Delivery, 29(2), 733-741.

Saunders, A., & Cornett, M. M. (2014). Financial ins