VARIOUS INNOVATIONS BEING USED TO DESIGN EQUITY & DEBT

INSTRUMENTS IN INDIASecurities Analysis & Valuation

Group 2Parth KushwahaShivam GuptaShubham RandharAditya KondawarNVR SandeepNVR Pradeep

Introduction

Debt instruments are typically agreements where a financial institution agrees to loan a

borrower money in exchange for set payments of principal and interest over a set period of time.

Debt instruments typically involve loans, mortgages, leases, notes and bonds. Basically, anything

that obliges a borrower to make payments based on a contractual arrangement is a debt

instrument. Debt instruments can be secured or unsecured. Secured debt involves placing an

underlying asset (like property) as security for the loan where, through legal process, the lender

can take possession of the underlying asset if the borrower stops making payments. Unsecured

debt is based only on the borrower's promise to pay. If a business files for bankruptcy, creditors

take priority over investors. Within the creditors, secured creditors take priority over unsecured

creditors.

Equity instruments are papers that demonstrate an ownership interest in a business.

Unlike debt instruments, equity instruments cede ownership, and some control, of a business to

investors who provide private capital to a business. Stocks are equity instruments. Two main

types of stocks exist. The first type is preferred stock. The second type is common stock.

Businesses issue stock in shares and, typically, the greater the amount of shares a single investor

possesses, the greater the ownership interest in the company. Equity holders incur greater risk

than debt holders because equity holders do not enjoy priority in a bankruptcy proceeding.

However, equity holders earn greater returns if the business succeeds. Where credit instruments

provide set payments over a set time period, equity instruments typically provide a variable

return based on the business' success.

Innovations in equity instruments

Arbitrage Fund

Arbitrage Funds are equity and derivative funds providing an ideal way of realizing reasonable

returns from equities with risk hedged by derivatives. The Arbitrage Fund capitalize on the stock

price differences between the spot market (cash segment) and the derivative market (F & O

segment). The fund generates returns by availing the arbitrage opportunities that arise in case

there are mispricing between the spot and derivative market. The returns can be generated

irrespective of the overall market movement. Empirically they have shown better results then

debt or income funds. They provide good returns during volatile periods.

Equity With Differential Voting Rights

Issued by Tata Motors, in which the shares were classified as “Ordinary Shares” and “A

Ordinary Shares”. The ordinary shares were issued at Rs. 340 per share, had a voting right of one

vote per share. On the other hand, the A ordinary shares were issued at Rs. 305 per share but the

voting rights were limited to one vote for every 10 shares. In addition, they were paid extra

dividend of five percentage points.

Indian Depository Receipts (IDR)

After the success of American Depository Receipts and Global Depository Receipts the Indian

regulatory body, SEBI also allowed foreign companies to raise capital in India through INDIAN

DEPOSITORY RECEIPTS (IDRs). IDRs can be understood as a mirror image of well-known

ADRs/GDRs. In an IDR, foreign companies issue the shares to an Indian Depository, which

would, issue Depository Receipts to investors in India. The Depository Receipts would be listed

in Indian stock exchanges and would be freely transferable. The actual shares of the IDRs would

be held by an Overseas Custodian, who shall authorize the Indian Depository to issue the IDRs.

The Overseas Custodian must be a foreign bank having business in India and needs approval

from the Finance Ministry for acting as a custodian while the Indian Depository needs to be

registered with the SEBI.

Debt For Equity And Equity For Debt Swaps

A debt for equity swap is not an instrument but a situation where a company offers its

shareholders and creditors debt in exchange for equity or stock. The value of the stock is

determined on current market rates. The company may, however, offer a higher value to attract

more shareholders and debt holders to participate in the swap. Equity for debt swap is the

opposite of the above process. In this swap, the creditors to the company agree to exchange the

debt for equity in the business.

Innovations in Debt Instruments

Zero Coupon Curve For Pricing

To bring further improvements in the pricing mechanism in debt market, a need was felt to

promote a zero coupon yield curve (ZCYC). As indicated earlier, STRIPS (Separate Trading of

Registered Interest and Principal of Securities) can facilitate a ZCYC. This curve is being used

for pricing NSE's interest rate futures transactions. FIMMDA/PDAI, publishes a monthly ZCYC

for the market participants to value their government securities portfolios. However, the ZCYC

based pricing has not been popular with the Indian market participants

Inflation Linked Bonds  

The recent Monetary Policy released by RBI laid its thrust on controlling the spiraling inflation,

especially the food price inflation. One of the reasons behind the CRR hike was to "curtail the

rising inflationary expectations (higher expected price trends)" In the past RBI has been

concerned about the fact that a common man does not have any protection against rising prices,

Vis No Inflation Hedge. The common man has to rely on traditional but inefficient methods to

hedge the real inflation risks, such as Gold and real assets such as commodities or real estate or

even excessive stocking of goods. In developed markets like US, the government has issues

"Treasury Inflation Protected Securities" known as TIPS. Globally more than USD 1 trillion

worth inflation linked bonds must be outstanding.

Triple Option Convertible Debentures (TOCD)

First Issued by Reliance Power Limited with an issue size of Rs. 2,172 Cr. There was no outflow

of interest for first five years. Equity increase was in phases. No put option to investors and no

takeover threat. Reduced dependence on the financial institutions. The expenses for floating the

issue was just 2.62% of the issue size which was very less when compared to the 10-12% for a

general public issue. Had reliance power limited gone for general public issue it would have

incurred a cost on capital by Rs. 239 crores approx. whereas by issuing TOCD the company

saved Rs.182 crores and incurred a cost of only Rs.57 crores.

Equity With Differential Voting Rights

Issued by Tata Motors, in which the shares were classified as “Ordinary Shares" and "A

Ordinary Shares". The ordinary shares were issued at Rs. 340 per share, had a voting right of one

vote per share. On the other hand, the A ordinary shares were issued at Rs. 305 per share but the

voting rights were limited to one vote for every 10 shares. In addition, they were paid extra

dividend of five percentage points.

Deep Discount Bonds

A bond that sells at a significant discount from par value. A bond that is selling at a discount

from par value and has a coupon rate significantly less than the prevailing rates of fixed-income

securities with a similar risk profile. Typically, a deep-discount bond will have a market price of

20% or more below its face value. These bonds are perceived to be riskier than similar bonds and

are thus priced accordingly. These low-coupon bonds are typically long term and issued with

call provisions. Investors are attracted to these discounted bonds because of their high return or

minimal chance of being called before maturity.

The investor got a tax advantage and could eliminate the re-investment risk.

From the issuer's point of view also, the issue cost was saved as it involved no immediate service

cost and lower effective cost. The refinancing risk was also eliminated.

Conclusion

The pace of capital and credit reforms is rapid and is transforming the scenario. The existence of

a variety of financial innovations with different terms and conditions, now provide a wide choice

of instruments to suit the investment portfolio needs. They have led the growth of capital market

and would continue to play their part, yet like other emerging market, Indian market is also

evolving and maturing.  It is in a favorable situation with regard to lesser complexity of

instruments, adequate governance and risk management systems. Indian capital market

innovations have the feature of investor protection, transparency, enhanced liquidity, reduced

cost and mitigation of risk. However, when compared with other developed economies, Indian

markets lack depth. Initiation of further reforms is necessary to develop innovative capital

market instruments to match those of its peers in Asia and other developed nations. There are

significant opportunities for productive and prudent financial innovation, especially for senior

citizens, poor people, women and rural people as well as a large middle class. There remains

scope for development of insurance exchanges, credit reinsurance market, carbon market,

property future, weather derivatives, freight derivatives, inflation derivatives