eFinanceManagement https://efinancemanagement.com FINANCIAL MANAGEMENT CONCEPTS IN LAYMAN’S TERMS Sat, 20 Feb 2021 13:14:15 +0000 en-US hourly 1 https://efinancemanagement.com/wp-content/uploads/2021/01/cropped-eFM_favicon-1-32x32.png eFinanceManagement https://efinancemanagement.com 32 32 Blue Sky Laws https://efinancemanagement.com/investment-decisions/blue-sky-laws https://efinancemanagement.com/investment-decisions/blue-sky-laws#respond Sat, 20 Feb 2021 13:14:12 +0000 https://efinancemanagement.com/?p=39874 What are Blue Sky Laws?In order to protect investors dealing in securities from fraud, there are some Federal Securities laws at the country level. But, in addition to them, every state in the US enforces its own set of laws called Blue Sky Laws. Thus, Blue Sky Laws are state regulations and their purpose is ... Read more

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What are Blue Sky Laws?

In order to protect investors dealing in securities from fraud, there are some Federal Securities laws at the country level. But, in addition to them, every state in the US enforces its own set of laws called Blue Sky Laws. Thus, Blue Sky Laws are state regulations and their purpose is to safeguard investors from securities fraud. And these being the laws promulgated by the states, there may be some variations in the rules and regulations state-wise for these blue sky laws. Moreover, this also suggests and implies that the issuer of securities needs to comply with the state laws as well for offering securities to the public.

Mandates of these Laws

Now, though Blue Sky Laws can vary by state (as every state has its own set of them), there is some commonality. They typically require the seller of new securities to register their offerings before selling them in the market. These laws also demand financial info of the deal from the seller/company. Licensing of brokers, brokerage firms, and investment advisors is also mandatory under these laws.

The company issuing the security must reveal the terms of the offering. Any other information which can affect the security also has to be disclosed. As a result of all these mandates, the investors get sufficient information and thus can make well-informed investment decisions.

Since Blue Sky Laws are state laws, the filing requirements of different states can vary. The issuer has to fulfill filing requirements for each of the states in which the entity wishes to issue securities. The state delegates also decide on the fairness of the deal for the investors. The intention is to prevent the sellers from taking advantage of innocent investors who may not be able to determine what’s fair for them.

The securities listed on National Stock Exchanges are exempt from Blue Sky Laws.

Here, it is important to understand that state regulations do not take precedence over Federal Securities Regulations. Further, blue sky laws do not empower states to regulate the national sale of any security. The Securities and Exchange Commission is the supreme body in regulating the federal securities laws together with national stock exchanges.

The Origin of Blue Sky Laws

Basic Intent

The blue sky laws came up with the intent to safeguard and protect the interest of investors for ensuring that all the important information is disclosed to the public/investors at a fair and reasonable level, so as to assist them in taking a careful decision with regard to their investments. Further, to impose liability and penalties for false and misleading information. And to provide an administrative mechanism to regulate and enforce these laws.

History and Evolution of Blue Sky Laws

Blue sky laws took life in the early 1990s. Kansas is believed to have passed the inceptive blue sky law in 1911. Although the term came into existence when Kansas banking commissioner J. N. Dolley was pushing for the passing of the Kansas statue a year ago. He was declaring his intention to shield innocent investors from investing in ventures that have no foundation but feet of ‘blue sky’.

In those times, such unproven ventures were common. Companies used to make unsubstantiated claims about the prospects of the investment. These companies used to sell securities without producing any evidence to back their claims. There was hardly any administrative supervision of the market and the finance industry by any governing body.  Hence, frauds were common and corporates used to hide unfavorable details from the investors. This inflated the market in the 1920s before its fateful crash in 1929, known as the 1929 stock market crash or the biggest depression.

Beginning in 1911, by 1931 almost all the states in the US had blue sky laws in place. Hence, these state laws go before two federal acts took life in the US governing the issue and sale of securities. The first one is the Federal Securities Act, 1933. And, a year after, the Securities Exchange Act, 1934 was passed. Both are Federal Acts and do not assume the place of blue sky laws.

Blue Sky Laws

Other Subsequent Laws

In 1956, Federal legislators came up with the Uniform Securities Act. The purpose of this law was to provide a template or guide to the states to build and flair their own laws. And most of the states by that time had built their blue sky laws from this act. However, there were still many differences between different states. Practices that were appropriate in one state were inappropriate in another state. Thereby one act that was considered fraud in one state, was considered ok in another state. The judicial pronouncements also varied from state to state. The result was a complex set of laws and decisions which made it difficult for companies to issue securities in multiple states. And so, an even more uniform law was the need for.

Hence, in pursuit of a more systematic and homogeneous regime, in 1996 the US Congress came with the National Securities Markets Improvement Act. This law increased the federal government’s powers in the securities market and cut down states’ control in setting standards and specifying filing requirements. This law also labels some securities as covered securities. Securities categorized as covered securities are exempt from state registration requirements. Other subsequent federal laws limit the state courts’ jurisdiction in case of financial fraud. Blue sky laws, still, are an important regulation for issuers of security to abide by.

Let’s Highlight the Merits of the Blue Sky Laws

  • They bring all the necessary information about the company issuing the securities as well as the offer to the investors’ notice
  • Check for the credibility of the company issuing the security and ensure that the issuer is not a fly by night operator
  • They do a merit review of security offers to conclude if the offer is fair to the innocent investor
  • Issue liability to the company not fulfilling the registration requirements.
  • Provide an overall safe and healthy environment for securities dealing, and builds confidence among the investors

Major Limitations of the Laws

  • For companies who want to issue securities in multiple states, these laws create a complex list of regulations and registration requirements to follow, which may become difficult to follow.
  • A heavy burden of different regulatory requirements by different states falling on a single company may discourage them to grow their operations. Many corporates across the US feeling the same will translate into lower economic growth.
  • The Federal laws cut many of the state powers which makes states less mighty.

References

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Dirty Float https://efinancemanagement.com/international-financial-management/dirty-float https://efinancemanagement.com/international-financial-management/dirty-float#respond Fri, 19 Feb 2021 05:32:57 +0000 https://efinancemanagement.com/?p=39918 Dirty float, also known as the managed float is an exchange rate system in which the value of a currency is determined not only by the forces of demand and supply but also through some form of intervention by the central government or central banking regulator of that country. Let’s break this down for a ... Read more

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Dirty float, also known as the managed float is an exchange rate system in which the value of a currency is determined not only by the forces of demand and supply but also through some form of intervention by the central government or central banking regulator of that country. Let’s break this down for a more complete understanding.

What is an Exchange Rate?

Every country has an exchange rate system in place. An exchange rate is nothing but the value of one country’s currency in relation to another country’s currency. How many dollars a US resident has to pay in order to get one Japanese Yen is determined by these exchange rates. If you are going outside of the US for a vacation or you want to purchase goods from an online seller of some foreign country, you will want to understand the exchange rates to understand the deal value/transaction cost. This is why exchange rates exist: to facilitate business between any two countries or between two currencies.

What is an Exchange Rate System?

An exchange rate system then means how does a country want the exchange rate of its currency to be determined. There are majorly three exchange rate systems countries use to determine their currency’s exchange rate. Let’s briefly talk about them.

  1. Fixed exchange rate. Under this system, the central bank or the government fixes the value of its currency in relation to another country’s currency or in relation to gold. For example, the value of Danish Krone is fixed in relation to the European Union’s Euro at a (fixed)rate of 746.038 kroner per 100 euros.
  2. Floating exchange rate. Under this system, the exchange rate of a particular currency is determined completely by the forces of demand and supply.
  3. Dirty float is a system in which the exchange rate is determined primarily by the forces of demand and supply. But sometimes the government or the central bank interferes in the exchange rate system by purposefully buying or selling a large volume of its currency in order to influence its exchange rate.

What are the forces of Demand and Supply?

Under floating exchange and dirty float, the forces of demand and supply determine the exchange rate of a currency. Let us understand how and why the demand and supply of a specific country’s currency generate in the first place? Demand for our currency generates when the tourists want to visit our country, or when a foreign company wants to purchase raw material from our country, etc. Tourists will need our currency to stay here. Similarly, the foreign company will need our currency to make payments for the raw material. Likewise, supply for our currency generates when we give our currency in exchange for our foreign currency requirements. The more we need foreign currency, the more we will have to give away our currency in exchange. The more we give away our currency in exchange, the more its supply will result.

How do Demand and Supply Affect the Exchange Rate

The impact of demand and supply of the currency also follows the universal law of demand and supply. If the demand for a particular currency is higher (by tourists, businesses, etc) than its supply, its exchange rate will rise. Similarly, if the demand is lower than the supply, the exchange rate of that currency will fall. This rise and fall in the exchange rate are not for one time. It will keep rising or falling as long as the demand and supply do not become equal. And when this happens, the exchange rate will stabilize. It will remain stable till the time the demand and supply do not become unequal again.

How do Governments Interfere in Dirty Float?

Under dirty float, the government or the central bank of a country intervenes to change the equation of demand and supply. They do so by purposefully buying or selling their own currency. This intervention leads to an artificial or controlled change in demand and/or supply of the currency. For example, when the government of a country buys its own currency from the foreign exchange market, it is creating additional demand for its currency. Likewise, when the government sells its currency in the foreign exchange, it is creating additional supply for its currency.

Dirty Float

The Need for Government Intervention

Government intervention becomes necessary under extreme situations such as a natural disaster destroying large parts of the country or a major terrorist attack. These situations will call for heavy selling by investors who invest in foreign exchange. As a result of this heavy selling, the value of the currency will fall down sharply. Hence, governments interfere in these times to stop the currency value from falling and to restore it. What if the government does not interfere? Trade and commerce of the country will be impacted in a major way.

For example, if the value of the Chinese currency falls down sharply, Chinese businessmen will need more and more of their currency to exchange it for a unit of US dollars. The same product from the US which China used to import for say, 100 Renminbi will now cost it say, 150 Renminbi. Chinese businessmen will make losses as a result and the economy as a whole will suffer. As a result, government intervention becomes critical to restore the situation and save the economy.

Using Dirty Float to Advance Economic Interests

Under dirty float, however, the government interferes routinely and not just under extreme situations. It interferes frequently to advance its economic interests. For example, if the US government wants to invite investment from foreign sources, it may sell a huge volume of its currency in the foreign exchange market. As a result, the value of US currency will fall down and it will become cheaper for foreign companies to invest in the US. Also, imports from the US will also become cheaper for foreign countries which will translate into more business for domestic industries. This way, governments use dirty float to advance their economic interests.

Under Dirty Float, is it Devaluation or Depreciation?

To describe the loss in the value of a currency, we often use Devaluation and Depreciation. But it is not correct to use them interchangeably. Under dirty float, if a currency loses its value, the correct term to use is depreciation. It is so because depreciation signifies a loss in value because of the forces of supply and demand. Even if the government purposefully depreciates a currency, it does so by changing the equation of demand and supply. Moreover, it may remain a temporary phenomenon till the demand-supply equilibrium gets back to normal.

Devaluation, on the other hand, is the term appropriate for use in a fixed exchange rate system. It is so because devaluation is done directly by the government. Government devalues by changing the value of the currency in relation to the currency against which it is pegged. We learned that the value of Danish Krone is fixed in relation to the European Union’s Euro at a (fixed)rate of 746.038 kroner per 100 euros. Now, suppose if the Danish Government wants to devalue its currency, they may fix the exchange rate at 800 kroner per 100 euros.

Of course, both this happens because of the interference by the Government or the Central Banking Regulator. However, the key difference is the time horizon. Depreciation is a temporary intervention, whereas Devaluation is a permanent measure used to ease out the economic conditions or to improve the econmoic interests.

References

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Strategic Options https://efinancemanagement.com/financial-analysis/strategic-options https://efinancemanagement.com/financial-analysis/strategic-options#respond Thu, 18 Feb 2021 07:07:46 +0000 https://efinancemanagement.com/?p=40049 What is the meaning of Strategic Options? A strategy is a plan for the successful achievement of the organization’s goals over a period of time. It is always designed towards the achievement of a specific target or a goal. Also, it is always for the long-term. Strategic options are goal-oriented alternatives that an organization has ... Read more

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What is the meaning of Strategic Options?

A strategy is a plan for the successful achievement of the organization’s goals over a period of time. It is always designed towards the achievement of a specific target or a goal. Also, it is always for the long-term. Strategic options are goal-oriented alternatives that an organization has towards the external uncertain environment. It is not only the choice but also the obligation of the management to choose the best possible alternative. It should be done in context with the organization, its needs, its resources, its vision, and other similar considerations.

The determination of these options involves a thorough study of the organization’s strengths, weaknesses, opportunities, and threats from the internal as well as the external environment. This becomes more complex in case the organization has a portfolio of various businesses, or products. Similarly, it becomes complex to decide and implement if it operates in different geographies. Because the tastes and preferences of the customers may vary considerably. Then the proper evaluation of each of the options has to be done by the management. Each will have its own advantages as well as disadvantages. This involves a lot of brainstorming and making tough decisions and choices. After evaluation, comes the selection stage where one or multiple options can be chosen as per the need and circumstances. Also, the management needs to decide how these options will be put into use and practice.

Which Techniques are useful for making Strategic Options?

Some of the key techniques for the generation of strategic options are:

Using the Ansoff Matrix

The Ansoff matrix provides strategic options with regard to the growth of an organization. And what modifications/amends needed in the existing portfolio of products to grow. It takes into account new and existing markets, new and existing products, and their inherent risks. After analyzing these aspects the matrix provides four different strategic options. And these are Market penetration, Market development, Diversification, and finally fourth being Product development.

The matrix helps to guide and make decisions to sell the existing products and services to new customers and clients, altogether new products and services to the existing clients, or new products and services to new clients. Thus, it can be a very useful tool to provide sales and growth options along with an outline of their risks. It is a widely used tool due to its ease of use and simplicity. In other words, this matrix is a quick and simple way of understanding and appreciating the risks of growth.

Using the Innovation Matrix

The Innovation matrix provides a formal structure to promote and manage innovation in an organization. It helps to create strategies that can help to simplify and design techniques for effective thinking. This can act as a tool for innovation.

It promotes the use of three key steps: Think, Strategize and then finally Act in order to promote innovation and innovative techniques within the organization.

Porter’s Generic Strategies

Porter’s Generic Strategies is a framework to plan the direction of the organization. It suggests ways to gain a competitive advantage in the market. This tool gives an organization a roadmap to get an edge over the competitor by taking sales away from them and establish leadership in the market.

Porter’s generic strategies suggest the use of three key strategic options: Cost Leadership, Differentiation, and Focus. These three options aim at giving a competitive advantage to an organization and evolve as a leader.

Cost leadership advocates capturing a bigger pie of the market share. This can be done by lowering costs or increasing profits by maintaining average and competitive prices. Also, this option advocate minimizing costs so that it is lower than that of any competitor.

The strategy of differentiation focuses on offering products and services with a tinge of differentiation or uniqueness. The offerings of the organization should be such that they provide additional value and features than that any competitor provides.

The strategy of focus pushes an organization to gain a competitive advantage. This is done by focusing on niche markets and clientele. The organization can either use cost leadership or differentiation to achieve this goal.

Using a BCG Analysis

The BCG Analysis is an important tool for companies to determine where their products stand in front of the competitor’s products. It provides answers to important questions like which products to invest in and grow; which products to develop more and finally, which products to discontinue or stop investing in.

The matrix has “rate of growth of the market” on the y-axis, and “relative share in the market” on the x-axis. Organizations can divide their products into four categories and place them in the matrix: Cash cows, stars, dogs, and question marks. Cash cows generate positive and good cash flow, stars are products with maximum market share and cash generation potential, question marks have high growth rate and potential to grow, but currently have a low share in the market. Finally, the dogs have very limited future growth potential. Hence, an organization will be better off to stop further investments in this category of products.

SWOT Analysis

SWOT analysis also provides relevant strategic options for an organization. It helps to fight competition and is useful in doing project planning. The meaning of SWOT is S for strengths, W for weaknesses, O for opportunities and finally T for threats.

An organization can make use of the analysis for decision making and decide whether the option will help it to meet its goals and objectives.

Pareto Analysis

Pareto Analysis helps to analyze multiple choices or alternatives that are available to an organization. It helps to figure out the benefits a company can expect with each of the alternatives, and then the best course of action to implement that choice. The main goal is to derive as much benefit as possible from that choice of action.

The analysis depends upon brainstorming and bringing out new ideas from the management. Also, it results in the active involvement of each and everyone involved in the process of chalking out the strategic options in the organization.

Strategy Canvas

Strategy canvas or Blue ocean strategy canvas helps to compare the strategic profile of an existing market with that of the new entrant or the company. The strategy helps to develop a “blue ocean market”. It means that it focuses to continuously discover newer markets that have a limited presence of the competition and have good growth potential.

Also, the canvas is strictly against venturing into “red oceans” or the markets that already have a lot of competition present and are already saturated.

Strategic Options

What Strategic Options does a company have?

An organization can opt for any of the following strategic options as per its needs and requirements, and the stage it is in its lifeline-

Diversification strategy

A company may opt for a diversification strategy in case of saturation of its already existing markets and product portfolio. It can plan to diversify into new markets, new products and even opt for foreign markets for expansion.  

This strategy is helpful in achieving economies of scale and scope. It enables companies to make the best possible use of inexpensive resources of foreign countries and bring down its costs. Companies can benefit from the already established brand name, and make use of their already existing know-how, techniques, processes, and patents. Thereby they can gain a competitive advantage over others and become market leaders with improved market share and profitability with relative ease.

Restructuring strategy

The strategy of restructuring means that a company may choose to restructure some of its unprofitable product lines or processes. It may discontinue them, and make entirely new acquisitions to substitute them.

This strategy is useful for those companies that have products in their portfolio that have become unprofitable or are starting to become unviable to continue with. Or the products that are towards the end of their lifecycle/existence. It is a sort of reorganization of a company that may help it to free some of its underutilized or unviable resources. Redeploying them towards growth will improve the overall status of the company.

Harvesting strategy

This strategy involves the reduction of business assets to the bare minimum and freeing up the resources and capital of the business. Such a strategy leads to the stoppage of new investment in the business, whereas cash flow increases in the short run. The end road of such a strategy is generally liquidation of the business.

Turnaround strategy

Turnaround strategy is nothing but bringing an unprofitable or dying business back to life. Instead of harvesting, a company may choose the strategy of investing in new resources and turn back the business into being profitable.

The adoption of such a strategy can be done when the industry prospects look bright and profitable in the long run, even though the business suffers losses in the short run. It may choose to cut costs, invest in new products and regions, or change its business strategy altogether.

Divestiture strategy

A company may choose the strategy of divesting its business unit, or a part of it if it continues to be unprofitable for a long time. Also, the company may find limited growth opportunities for the same in the future too. The company may either go for “spinoff” in which it sells the portion to outside individuals. Else it may opt for a “management buyout” in which the company’s management itself buys that unit.

Companies may opt for this strategy when they intend to concentrate solely on their core business, or when they are unable to manage the diversified portfolio of the company properly.

Strategy of liquidation

This is the last option that a company intends to take. The company writes off an investment since it is not able to find a suitable buyer for the same. It takes such an extreme step in case of financial or managerial failure of the business unit. The collapse becomes inevitable or else the unit may continue to drain the company’s valuable resources.

Strategic Options: Conclusion 

A company should be extremely cautious and thoughtful before choosing a particular strategy. It should continue to look for better options even when it has chosen one. This process is continuous and never-ending for the management. Choosing a strategy option may call for a tough choice or even a trade-off on the part of the management and it should be ready for it.

While going for multiple options, the management must always abide by the company’s core values and missions. It should ensure that the options work in tandem with each other, no friction is created between them and the departments and they meet the end objective of a high growth rate along with high profits.

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Functional Currency – Meaning, Importance, How to Determine? https://efinancemanagement.com/international-financial-management/functional-currency-meaning-importance-how-to-determine https://efinancemanagement.com/international-financial-management/functional-currency-meaning-importance-how-to-determine#respond Wed, 17 Feb 2021 11:57:49 +0000 https://efinancemanagement.com/?p=40053 Functional Currency (FC), as the word suggests, is the currency of the location or the economic environment in which a firm works. Or, we can also say that it is the currency in which a firm mainly earns and spends cash. In simple words, we can say that it is the home currency of the ... Read more

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Functional Currency (FC), as the word suggests, is the currency of the location or the economic environment in which a firm works. Or, we can also say that it is the currency in which a firm mainly earns and spends cash. In simple words, we can say that it is the home currency of the country in which the company is headquartered. But that may not be the case always. The local currency and the FC can be different. 

FASB (Financial Accounting Standards Board) was the first to come up with the idea of functional currency. As per the definition by IAS (International Accounting Standard) 21, it is the currency of the “primary economic environment in which the entity operates.”

There are several things that assist in determining the functional currency. In most cases, it the local currency in which a firm operates, or the currency of the parent company. But, in a number of cases, the U.S. dollar serves as the FC. This is because all major industries support USD by pricing their goods and services in this currency.

A good example of this is oil. This means if oil constitutes a sizable portion of a company’s business, then fluctuation in the USD would impact its performance. So, in this case, the USD will serve as the functional currency even if the company generates invoices in local currency. 

Functional Currency – Importance

It is very crucial for a company to identify its functional currency. As one would appreciate, the concept of functional currency is applicable to companies that operate internationally. Or, the firms doing business in more than one currency, and hence face currency risk.

Basically, selecting a functional currency addresses reporting issues. These issues include recording of foreign currency transactions, as well as treatment of foreign subsidiaries’ financial statements.

Moreover, deciding on currency helps in measuring the overall performance of the business. Also, it ensures that a company’s financial statement shows the actual position. 

Converting Other Currency to Functional

It is possible that functional and reporting currency could be different. That is why both U.S. GAAP and IAS detail processes on how firms can switch their transactions in other currencies to FC. When converting transactions, the exchange rate can affect the overall performance.

For conversion, mostly the exchange rate prevailing on the day of transactions is considered. Also, there are cases when companies use a standard rate, like the average or the maximum rate. When converting foreign currency into FC, a company must follow this process:

  • It must first identify its FC.
  • Then it needs to convert all transactions into the FC.
  • Now, the company needs to report the effect of converting the transactions as per the IAS 21.

How to Determine Functional Currency?

A point to note is that an FC may or may not be the reporting currency for the company. In some cases, determining FC could be straightforward, but in some, it could get tricky.

Three easy ways to identify a functional currency are:

  • It is the currency that impacts the prices of products or services that a company sells.
  • If the regulation on a currency impacts a company’s pricing policy, then that currency is a functional currency.
  • It is the currency that impacts the costs and expenses of a company.
  • It should be the currency in which the company prices its inventory, labor, and expenses.
  • Also, it is usually the currency in which a company issues its debt and equity instruments.

To determine the functional currency of a company’s foreign operations, the management must look at the following points:

Functional Currency

Autonomy

Management must try to identify the degree of autonomy the foreign operations enjoy. If the operations are just an extension, then the currency remains the same. And, if the foreign operations enjoy a great deal of autonomy, then the local currency is the FC. 

Transactions Volume

The company needs to determine whether or not the transactions with the foreign entity represent a significant portion of the total operations. If the amount of transactions is considerable, then the foreign currency becomes the FC.

 The proportion of Cash Flows

One needs to determine whether or not the cash flows from the foreign entity represent a significant proportion of the company’s total revenue. If the foreign cash flows are more than the local, then the foreign currency is the FC.

Debt Service

Another deciding factor is if the cash flows from foreign operations are sufficient to meet its debt obligations. Or, the foreign operations don’t require any funds from the company to service its (foreign operations) debts.

Examples

Let’s take a simple example to understand the concept of this currency. A Chinese company has its headquarter in Beijing, but operates in the U.S. as well. In fact, the U.S. market accounts for more than 50% of the company’s total revenues. So, the functional currency for this company would be the U.S. dollar and not the Chinese Yuan.

In another example, a U.S. company has a Chinese subsidiary. The revenue and expenditures of the subsidiary are more or less the same in the U.S. dollar and Yuan. In this case, the subsidiary can choose either currency. However, the better solution, in this case, will be selecting Yuan because it is the local currency. 

In cases where a company has operations in two or more currencies, and all markets are equally important, then it is up to the management to decide the functional currency. The management should take into consideration the relationship with clients, financial results, investors, regulations, and other factors to decide on the currency.

Final Words

Deciding FC is very important for a multinational corporation. Only after the company selects FC and converts transactions into FC, it could give its true financial picture. A point to note is that a company can’t change its FC once it selects. However, it may change FC under a few rare circumstances and events. And, if the company changes its FC, then it should implement the change from the first day, i.e. prospectively and not retrospectively. 

References

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Cross Hedge https://efinancemanagement.com/investment-decisions/cross-hedge https://efinancemanagement.com/investment-decisions/cross-hedge#respond Mon, 15 Feb 2021 22:51:00 +0000 https://efinancemanagement.com/?p=39913 Fly High is an airline company. They expect that the prices of jet fuel will rise over a period of three months. So, as the prices of jet fuel will increase, their cost of flying passengers will also rise. They may or may not be able to raise the prices of their tickets or passenger ... Read more

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Fly High is an airline company. They expect that the prices of jet fuel will rise over a period of three months. So, as the prices of jet fuel will increase, their cost of flying passengers will also rise. They may or may not be able to raise the prices of their tickets or passenger fare, with the rise in fuel prices. If they do not increase the passenger fare, their profits from each seat in the airplane they sell will go down. So, what is the option with the airline, and what steps they should take to ensure that their profits do not go down? The answer lies in entering into the cross hedge.

Cross Hedge is a futures contract strategy or a financial strategy to offset or minimize the loss from one asset from the profits of the other asset. In cross hedge, you purchase two different assets/security/commodity in the futures market with a positive correlation in the movement of their prices. You do this because you consider holding just one of the assets as risky.

What is this Futures Market?

The futures market is a platform where the buyers agree to buy something and the sellers agree to sell it at a predetermined price and on a specified future date. This kind of contract, in which the price of the item is set on today’s price but the delivery is to be made on a future date, is called a futures contract.

Positive correlation in prices of two assets will mean, that if the price or value of one of the assets rises, the price of the other will also rise.

Cross Hedge Real World Scenario: 1

So, if the Fly High airlines expect the cost of jet fuel to rise in the future, they can purchase crude oil in the futures market. If the price of jet fuels rises in three months’ time, the price of crude oil, we expect, will also rise (since their prices are positively correlated). Now, fly high has purchased crude oil at today’s low price, and they will get it after three months when the prices will be higher. They can sell that crude oil at that higher price in the future. This way, the risk of profits going down because of the increase in jet fuel price, is taken care of. The profits they will make with crude oil trading will compensate for any loss with rising in jet fuel prices. This process is called cross hedging.

Cross Hedge Real World Scenario: 2

Consider the opposite situation. What if a company expects the prices of their asset(s) to go down? Fly high airlines won’t be worried about this as this will bring down their costs. But if you are the owner of a gold mine and you expect the value of your stock of gold (inventory) to go down, you will have a lot to worry about. How do you cover this risk? You can sell that asset or a related asset at today’s price in the futures market.

Suppose you are holding a substantial amount of gold inventory and you can make profits on them as long as the prices are above $1400 per ounce of gold. Currently, the prices are around $1500 per ounce. But you expect prices to fall below $1300 per ounce and stay there for a long time. How can you cover this risk?

You can sell gold in the futures market at today’s prices and sell all the inventory of gold you hold. But you are not able to find gold futures contracts to cover your risk. So, you enter into a cross hedge by selling platinum in the futures market as prices of gold and platinum are highly correlated. So, you sell that amount of platinum in the futures market which is roughly equal to the value of your gold inventory. Now, when the gold prices fall below $1400 per ounce, you will make losses. But you will cover the losses by delivering platinum which you now purchase at a low price but you had sold it at a higher price in the past through a futures contract.

Cross Hedge

In general, businesses or other entities can cover this risk of a rise or fall in the value of their asset through futures contracts. The need for cross hedging arises when the exact asset is not available in the futures market. So, when the perfect asset is not available for hedging, companies search for the closest alternative asset. The task is to find an asset in the futures market which shows a positive correlation in its price with the asset we already own or will have to purchase.

However, in businesses, as in life, you cannot cover all the risks. There is still a risk that the prices of the two assets may not show that positive correlation in the future. In our example, you knew that the prices of gold and platinum will both fall. But it may happen that the prices of platinum start rising while the gold is falling. In that case, you will make losses in gold and an additional loss by purchasing platinum at a higher price.

Degree of Correlation

In cross hedging, we also have to consider the degree of correlation between the two assets. Suppose, if the correlation between crude oil and jet fuel is 0.5. That means for every rise of $2 in the price of crude oil, the price of jet fuel will rise by $1 only. That means you need to purchase only half the quantity of crude oil to cover the entire quantity of jet fuel.

Problems in Cross Hedging

Cross Hedge as a technique suffers from some limitations because of the following factors

  • Mismatch in hedging horizon. You expect the prices of gold to remain down in the November-December period. But your futures contract in platinum expires in March next year
  • Mismatch in size of the risk covered. It may happen that you want to cover the prices of all the gold that you will mine in the next year but you do not get such a big futures contract
  • Asset mismatch. There may not be a good alternative asset for you to engage in a cross hedge. The prices of the assets do not correlate properly with each other. Or worst, they may correlate highly in one period and poorly in another period. In that case, cross hedge itself becomes risky and is not useful.

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Maturity Risk Premium – Meaning, Need, and Calculation https://efinancemanagement.com/investment-decisions/maturity-risk-premium-meaning-need-and-calculation https://efinancemanagement.com/investment-decisions/maturity-risk-premium-meaning-need-and-calculation#respond Mon, 15 Feb 2021 12:17:46 +0000 https://efinancemanagement.com/?p=39986 Maturity Risk Premium is basically the extra return that an investor demands or gets for bearing the maturity risk. Usually, the concept of maturity risk applies in the case of a bond. A long term bond offers a premium, in the form of a higher interest rate, to compensate for the higher risk investor takes ... Read more

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Maturity Risk Premium is basically the extra return that an investor demands or gets for bearing the maturity risk. Usually, the concept of maturity risk applies in the case of a bond. A long term bond offers a premium, in the form of a higher interest rate, to compensate for the higher risk investor takes due to higher maturity.

We can say, longer the maturity of a financial instrument, the more is the maturity risk premium it offers. This is a major reason why the interest rates on longer-term securities are generally more than the short-term securities.

This risk premium plays a significant role in determining the price of a bond.

Need for Maturity Risk Premium

One big risk of investing in a long-term bond is that it could lose value before maturity.  When you purchase a bond, you are basically investing money or lending money to the issuer. The issuer, in return, is obligated to make regular interest payments at a pre-defined frequency and principal payment at maturity.

For instance, if you invest in a two-year bond, you get the money back at the end of two years. But, in a 30-year bond, you need to wait for thirty years to get the money back. Not much could change in two years, but in 30 years, many things could change. The changes could be various that may have a severe impact on the payment status of the interest and principal of the bonds.

The change could be the issuer running into financial hardships. If such is the case, then the bond issuer may be unable to make payment of interest on regular intervals or principal amount on maturity or both. Moreover, there is also a risk that the market interest rate goes up (interest rate risk), leading to a fall in the bond’s intrinsic value.

Security with longer maturity has reinvestment risk as well. This is the risk of cash flows, which the investor gets over the life of the bond, can’t be reinvested at a higher interest rate.

These are the reasons why investors in long-term bonds need an extra incentive. And this extra incentive comes in the form of a maturity risk premium.  

Maturity Risk Premium and Interest Rate Risk

There is a very close connection between the concept of maturity risk premium and interest rate risk.

If you invest in a bond, the issuer undertakes to pay a set rate of interest and the principal at maturity. There are chances that before maturity, the market rates rise. In such a case, the bond you invested in gives you interest at a lower than the market rate.  This risk of the interest rate rising more than the set rate is the interest rate risk.

The maturity risk premium helps to offset this risk by raising the interest rates on the securities with longer maturity.

Market Risk Premium

How to Calculate?

We can easily calculate this premium if we know the maturity date of the bond and the interest it offers. For simplicity, we are assuming that the investor wants to invest in a 10-year bond.

Risk-Free Rate

Next, one will have to get the yield for risk-free securities, which have the same maturity as the bond. One best way to get the risk-free yield is to look at the interest rate of the Treasury securities. These securities are risk-free as the U.S. government backs them.    

Once you get the risk-free rate, subtract it from the interest that the 10-year bond offers. The result you get is the minimum risk premium for investing in a 10-year bond.

Example 

Let us try to understand this premium concept with the help of an example. Suppose, one-year Treasury bill has a yield of 0.60%. On the other hand, the 10-year bond is offering a rate of 1.91%.

Maturity Risk Premium = Interest rate of Bond Less Treasury bill yield

or 1.91% Less 0.60% = 1.31%.

Now suppose, you need to calculate whether or not the return offered by a bond you want to invest in is appropriate or not. For this, you will have to calculate the required rate of return. To calculate this return, you must know the risk-free rate. Also, you should know the default and the liquidity risk premium.

To get the required return, we need to add all these premiums, as well as the maturity premium to the risk-free rate.

Assume you want to compute the required rate of return for a 15-year bond. The risk-free rate is 2.3% (10-year Treasury bond), the liquidity risk premium is 0.3% and the default risk premium is 2.5%.

We first need to get the maturity premium. To calculate this premium we need to subtract the yield of the 15-year Treasury bond from the 10-year Treasury bond. From this, we will get the maturity premium for the five years because we are taking the risk-free rate of a 10-year Treasury bond. For the sake of simplicity, let’s say the maturity premium is 1.5%.

Now, the required rate of return will be:

Risk-free rate plus liquidity risk premium plus default risk premium plus maturity premium

= 2.3% + 0.3% + 2.5% + 1.5% or 6.6%

So, if the 15-year bond that the investor plans to invest in is offering less than 6.6%, then the investor must not invest in it.

References

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Indexed Bonds: Meaning, Examples, Advantages and More https://efinancemanagement.com/sources-of-finance/indexed-bonds-meaning-examples-advantages-and-more https://efinancemanagement.com/sources-of-finance/indexed-bonds-meaning-examples-advantages-and-more#respond Sat, 13 Feb 2021 12:22:33 +0000 https://efinancemanagement.com/?p=39960 Indexed Bonds: Meaning A bond that releases interest payments on the basis of a particular price index is known as Indexed Bonds or Index-Linked Bonds or Inflation-Indexed Bonds. The Central Government of the country mostly issues this type of Bonds which are mostly for the medium term or long term. Although, State Government or Corporations, ... Read more

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Indexed Bonds: Meaning

A bond that releases interest payments on the basis of a particular price index is known as Indexed Bonds or Index-Linked Bonds or Inflation-Indexed Bonds. The Central Government of the country mostly issues this type of Bonds which are mostly for the medium term or long term. Although, State Government or Corporations, also issues Indexed-Linked Bonds these days. Under Index-Linked Bonds, the benchmark price index which is taken into consideration for the calculation of all interest payments is mostly Consumer Price Index (CPI) or Retail Price Index (RPI). The selection of benchmark takes place in accordance with the inflation effect on the investment. The investors get a real interest rate under this Bond investment.

The coupon rate for interest remains fixed in Indexed-Linked Bonds. And interest payments happen mostly on a semi-annual basis. While calculating returns/interest on payment dates on these Bonds, inflation-adjusted principal value is taken into consideration. Indexation factor (also known as the Index Ratio) is useful, in order to calculate, inflation-adjusted principal value.

Indexation Factor = Current Consumer Price Index (CPI)/ Consumer Price Index (CPI) at the time of issuance

Indexed Bonds has different names in different countries like in Canada, they are known as Real Return Bonds, in the United Kingdom, they are known as Linker and in the United States of America, they are issued as TIPS (Treasury Inflation-Protected Securities) or Inflation-Indexed Savings Bonds (I-Bonds).

Examples of Indexed Bonds

Let’s understand, Indexed Bond with few hypothetical examples:-

Example 1

Suppose ADS Bonds are issued at a face value of $1000, with a coupon rate of 8% and a maturity of 1 year. Moreover, the payment of interest will happen on maturity together with the Principal amount. Further, assume The Consumer Price Index at the time of Issuance is 155. Whereas, the Consumer Price Index at the time of maturity is 160.

Indexation Factor = 160/155 = 1.032

Inflation Rate = (160-155)/ 155 * 100

= 3.22%

At the time of maturity, the principal and interest repayment would be $1080 (1000 + 1000* 0.08).

The repayment value after considering inflation will be as follows:-

1080 * 1.032 = $1114.56

Thus, the total payment on maturity would be $1114.56. This amount consists of Original Principal: $1000; Interest at Coupon Rate of 8% $80, and the inflation factor $34.56 (1000+80+34.56).

In the above example,

The nominal Annual Interest Rate (AIR) = (1114.56- 1000)/1000 * 100

Annual Interest Rate = 11.456%

Real Interest Rate = 11.456% – 3.22% (inflation) =

Real Interest Rate = 8.23%  

Example 2

Keeping all things constant as Example 1, the only difference is that the Consumer Price Index (CPI), at the time of maturity is 156.

Indexation Factor = 156/155 = 1.006

Inflation Rate = 0.645%

Total repayment amount at the time of maturity = 1.006 * 1080 = $1086.48

Thus $1086.48 would be repaid at the time of maturity.

Annual Interest Rate (AIR) = (1086.48 – 1000)/1000 * 100

Annual Interest Rate (AIR) = 8.648%

Real Interest Rate = 8.648 – 0.645

Real Interest Rate = 8.003%

Indexed Bonds

Advantages of Indexed Bonds

  • Indexed Bond provide inflation-adjusted returns to the investors, i.e. it provides real interest rates and protects from the effects of inflation.
  • These Bonds generally yield higher returns in comparison to other types of Bonds.
  • Indexed Bonds, in comparison to other types of Bonds, are less volatile and less risky.
  • As Government issues these types of Bonds, they are more authentic and risk-free in nature.
  • Indexed-Linked Bonds acts as one of the major sources of finance for the Government.
  • These bonds, boost the infrastructural projects of the Government, thereby enhancing growth in the country. They also boost the savings rate in the country, by enhancing savings in the economy.
  • Nationally recognized inflation indicators are in direct link with the Indexed Bonds, as a result; it hedges directly with the current price level in the economy.
  • Sometimes, the Government issues these bonds to redistribute wealth in the economy and save the middle class, retired or dependent people from the inflation effect.
  • Investors receive inflationary adjusted fixed coupon rate and principal at the time of maturity.
  • Indexed Bond allows premature redemptions, but does not give any additional tax benefit.
  • At the time of deflation, the investors, most of the time, at least receives the face value of their investment. Generally, returns do not go below that level.
  • There exists a zero correlation between the returns of any fixed-income security or stocks with the Indexed Bonds. This makes it unique.
  • Indexed Bonds are also useful as a diversification tool by the portfolio managers while managing the portfolios.

These advantages are non-exhaustive in nature.

Indexed Bond Vs Fixed Deposit

There are many differences between Indexed Bond and Fixed Deposit. When Inflation takes place in the economy, Indexed-Linked Bond releases higher returns. While, at the time of inflation in the economy, Fixed Deposit releases fixed returns. The real value of returns diminishes in the case of Fixed Deposits.

Indexed-Linked Bond, in comparison to Fixed Deposit, is more liquid in nature. Mostly, Fixed Deposits do not have any secondary market for trading. Indexed-Linked Bond is tradable in nature.  

These differences are non-exhaustive in nature.

Conclusion

According to few critics, there exist few limitations of Index-Linked Bonds. Irrespective of this, it is one of the most trusted investment instrument which gives real interest rates to the investors. The advantages have far outweighed the criticisms and Indexed-Linked Bonds plays a very important role in the economy. It helps in keeping the functioning of the Capital Market and Money Market in line. Indexed-Linked Bonds save the citizens of the country from the inflation effect and help their investment grow. 

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Security Market Line https://efinancemanagement.com/investment-decisions/security-market-line https://efinancemanagement.com/investment-decisions/security-market-line#respond Fri, 12 Feb 2021 06:08:01 +0000 https://efinancemanagement.com/?p=39896 What do we mean by Security Market Line? The Capital Asset Pricing Model is graphically represented by drawing the Security Market Line. It shows the amount of returns an investor can expect from the market with regard to the different levels of market or systematic risk. These risks are those whose elimination is further not ... Read more

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What do we mean by Security Market Line?

The Capital Asset Pricing Model is graphically represented by drawing the Security Market Line. It shows the amount of returns an investor can expect from the market with regard to the different levels of market or systematic risk. These risks are those whose elimination is further not possible by diversification. In other words, it depicts the relationship between the risks of a security, measurable by its beta coefficient, and the returns that one can expect from it at every level of risk.

The concept of the Security Market Line is very popular for portfolio management. It helps to derive the pricing of risky securities by plotting their expected returns. It takes into account the risk that comes along with such investments, as well as the cost of capital. Also, it represents the opportunity cost of an investment and guides an investor to compare an investment opportunity at market risk with a risk-free investment.

The other name for Security Market Line is the “characteristic line”. While graphically representing this line, we plot the beta or the asset risk on the x-axis. The plotting of the return an investor expects from a security is done on the y-axis.

Equation for Security Market Line

The Security Market Line basically represents the prevailing risk-free return and the beta coefficient of the security. The formula to calculate the expected return and plotting the Security Market Line is:

SML= Risk-free rate of return + Beta coefficient (Market rate of return – Risk-free rate of return)

Main Components of the Security Market Line

Let us go through the main components of the above equation in detail.

Beta

Beta or Beta coefficient is one of the most important components for using the Security Market Line. It is a numerical value and is a measure of how a stock or security will move when the entire market goes up or down. It measures the systematic risk or the non-diversifiable risk of an asset with regard to the market portfolio.

The overall market average of risk is assumed to be beta value 1. A security with a high correlation to the market will have a beta coefficient greater than one. Such securities fall in the category of being highly risky. On the other hand, a security with a beta coefficient of less than one has a low correlation to the market and is less volatile or less risky.

The above discussion is from a risk perspective. However, the universal law is that the higher the risk, the higher can be the return also. Therefore, securities having a beta coefficient of more than 1 or of course highly risky but in times of upward market trend, they are the ones that will fetch you more returns than the market indices. So higher volatility gives an edge in a rising market.

Suppose a security has a beta coefficient of 1.5. It will mean that it is 50% more risky or volatile than the average of the market. However, if the market goes up by 20%, such a security should go up by 1.5 x 20= 30%.

The Risk-free Rate of Return and Systematic Risk

A risk-free rate of return is the return that an investor will get with any security or investment with near-zero risk over a time period. Thus, it is the least an investor will get as a return from his investment. An investor will go for a riskier investment only if he gets a return that is higher than the risk-free rate of return. Or in other words that is the extra premium or return that attracts him to take extra risk.

This rate is just theoretical and does not actually exist as an option for an investor because every investment comes with some amount of risk. The calculation for this rate is simply done by taking the yield of the Treasury bond and adjusting or subtracting the current inflation rate.    

Systematic risk is the risk of operating in the market and that is the same and applicable to all the participants of the market. Diversification of investments does not eliminate this risk. Factors that cause such a risk can be economic and policy changes, interest rates, political disturbances, natural calamities, etc.

Expected Market Return

It is the rate of return available in the present scenario for various types of securities under consideration. In this exercise, we have the expected rate of return for all the available securities. This we compare with the risk-free return. And thereafter according to the gap/difference in the returns, the beta calculation, and ranking happens. Then finally based on the risk appetite and portfolio composition the securities for investment purpose is identified.

Time Value of Money

This concept means that an amount of money in hand is more worthy than the same sum of money at some future date. This is so because money has the potential to grow, either by investing it in some business activity, the stock market, or simply by depositing it with a bank and earn interest on it.

Thus, a prudent investor will want returns from his investment because of the risk he undertakes on his investment. His money has an opportunity cost- he can invest it in other avenues other than the current security investment option and still generate returns. Moreover, he will want higher returns on his investment from securities with a high beta because of the higher risk he will bear than the market average.

Security Market Line

Interpretation of the Security Market Line

In the field of finance, the Security Market Line has a slope when we present it graphically. An investor looks for extra returns to offset the extra risk he will be taking by investing in a particular security. Hence, the difference between the risk-free return available in the market and the expected return of the investor from such a risky security is named as the market risk premium. This market risk premium guides the slope of the SML. The slope will be steep with a high market risk premium, and gradually it will decrease as the market risk premium goes down. A zero beta security or a security with nil market risk premium has the risk-free rate as its expected rate of return.

The Security Market Line can reflect the correct pricing of an asset. It helps to ascertain whether a security is overpriced or under-priced and thus, is crucial for making prudent investment decisions. An asset will be under-priced or undervalued if it appears above the SML in the graph. It is so because it is giving a higher return than the market at a given level of systematic risk. Similarly, an asset will be overpriced or overvalued if it appears below the SML. The logic is the same- it is giving a return lower than the market at a particular level of systematic risk.

Example of a Security Market Line

Let us assume that the risk-free rate is 4%, and the market returns that an investor should expect is 15%. We have two securities in hand: A with a beta of 0.6 and B with a beta of 1.8.

Now let us calculate the expected market return from both the securities by using the SML equation.

Expected return for Security A: 4 + 0.6 (15-4)

= 4 + 0.6(11)

= 10.6%

Expected return for Security B: 4 + 1.8(15-4)

=4 + 1.8(11)

=23.8%

Thus security B has higher expected returns because it has a higher beta and hence, is riskier than security A.

Advantages and Disadvantages of the Security Market Line

The SML like any other indicator has certain advantages and certain disadvantages as well. Let us understand first the advantages it offers:

Advantages of SML:

  • The SML model along with the CAPM is very easy to use and easily comprehendible. It plays a major role in portfolio planning and management. It helps an investor or a portfolio manager to make rational investment decisions by charting the expected returns from securities and asset classes.
  • The model does not ignore systematic risk or market risk while giving the expected returns. This is important and helpful as such risk comes along with every investment opportunity and cannot be done away with.

Disadvantages of SML:

  • The SML and CAPM models use the risk-free rate as their basis for calculations. This rate can change, causing volatility and unpredictability in the results of the model.
  • The market returns an investor uses for calculations come from past results that are not certain to be the same in the current times or future. Also, they can be negative in the short term and change over time, causing the results to be unreliable.
  • Factors such as inflation or deflation, economic and political changes, or other macroeconomic factors such as unemployment can cause the slope of the SML to change or shift with time. Hence, the results will keep changing and not be constant.
  • The basis for calculations in this model is the beta coefficient an investor decides to take for his security. The results from the use of this model will go wrong if the calculation of beta is wrong or it changes with time.

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Development Impact Bond (DIB) – Meaning, Objective and More https://efinancemanagement.com/sources-of-finance/development-impact-bond-dib https://efinancemanagement.com/sources-of-finance/development-impact-bond-dib#respond Thu, 11 Feb 2021 06:28:17 +0000 https://efinancemanagement.com/?p=39879 Development Impact Bond or (DIB) is a financial tool that helps to fund development projects, usually of social nature. Basically, DIBs come in handy in funding social projects in low-resource countries. They are very similar to social impact bonds (SIBs), or we can say that they are a type of SIBs. So, DIBs also involve ... Read more

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Development Impact Bond or (DIB) is a financial tool that helps to fund development projects, usually of social nature. Basically, DIBs come in handy in funding social projects in low-resource countries. They are very similar to social impact bonds (SIBs), or we can say that they are a type of SIBs. So, DIBs also involve private investors.

Development Impact Bond – Number of Parties Involved

Usually, a DIB involves three types of parties. And, these three parties are – a private investor, an outcome payer, and the service provider. A point to note is that there can be more than one of each type of party (such as two investors or three service providers).

  • A private investor could be a group of investors or a fund. They give funds to implement a development project that has social benefits.
  • The service provider is generally a nonprofit organization. This organization implements the project and is responsible for the results.
  • If the project is successful, then the private investor gets the repayment (with interest) by the outcome payer. This outcome payer is generally a philanthropic organization. Since the repayment depends on the outcome, we also call DIBs a results-based financing instrument.
  • Along with these three, there is one more party, and it is the evaluator. This party helps to determine whether or not the project is a success.

Are DIBs a Bond?

DIBs are a relatively new form of financial instruments as they came into existence only in 2012. Though we call it a Development Impact Bond, it doesn’t have the usual features of a bond. DIBs do have a fixed term, but they do not give a fixed interest rate to the investors. Instead, the repayment to the investors depends on whether or not the project is successful.

So, if the project goes well, the investor (investors) will get the repayment from the outcome funder, who is usually a philanthropic organization. But, if the project is unsuccessful, there is no repayment to the investors. Thus, we can say that DIBs are high-risk instruments for investors.

In the real world, it is seen that the outcome payer pays back the investor even if the project fails, although a lesser amount. If the project fails, the outcome payer could pay back the investor, but without any interest, or forfeit some amount of capital.  

Payments could also be made on a reducing basis. For instance, if the results are 80%, then the outcome payer could pay 70% of the working capital. Or, if the 70% work is complete, the payment could be 60% of the capital.

The Objective of the Development Impact Bond

The primary objective of DIBs is to encourage private investors to fund and subsidize development projects in countries that lack resources.

Basically, DIBs are useful when a party is willing to pay for a project with a social cause. However, it is not willing to take any risk about the success or failure of the project and therefore not willing to put its money at stake. So, such parties remain on the lookout for investors, who are willing to take that risk in return for a premium.

Another reason why DIBs are growing popular is that the service provider gets the funds upfront. This means the provider can work without worrying about funds, or wasting time in raising funds continuously.

Usually, in a DIB project, there are a lot of funders, and each funder has its own set of conditions. This may make it very challenging to complete the task. But, since they get the funds upfront, the service provider gets greater flexibility in executing the project.  

However, a major criticism of DIBs is their dependence on data. It is the data that determines the success of a DIB, so any error in data could have serious consequences. Moreover, this also makes the whole process expensive, as well as time-consuming.

When are DIBs Applicable?

DIBs have more chances of being successful if they have:

  • Clear project yield, as well as measurable social outcomes.
  • The service provider (or providers) gets a reasonable time to implement the project.
  • The project has the availability of relevant outcome data.
  • There is a decent level of funding available for the project.

Following are the scenarios when DIBs are not applicable:

  • When the outcomes are very certain.
  • The regulatory environment isn’t conducive to the success of the project.
  • Project yield and measurable social outcomes are not clear.
  • If the partners lack or don’t show commitment.
Development Impact Bond (DIB)

How Development Impact Bond Works?

The DIB process kicks-off when the outcome payer comes with an idea of a project that can address some issues in low-income countries. Now, the philanthropic organization (outcome payer) gets in touch with the potential investors and the service providers.

The outcome payer explains the project to these two. Also, it promises to repay the investors with interest if the project is successful. Once they decide to work on the project, they settle on the quantifiable metrics to measure the success of the project.

The private investors fund the project by buying its bonds. And, the service providers then use the proceeds to work on the project.  

After the end of the pre-decided period, the parties or an independent auditor measure the success of the project on the basis of pre-defined metrics. If the auditor tags the project as a success, then the outcome payer makes the repayment to the investors.

Social Impact Bonds (SIBs) vs. Development Impact Bond (DIBs)

DIBs are very similar to SIBs, but there are a few differences between them:

A major difference between the two is that in a SIB, the outcome payer is usually the government. In DIBs, the outcome payer is generally a philanthropic organization.  

A government has many incentives to go for a public-private partnership. So, the government uses SIBs and directs the public funds for the development projects. Also, with SIBs, the government doesn’t take the full risk; rather, the risk is spread across stakeholders.

How Much DIBs Cost?

Like any other project, the cost of a DIB depends on the result of the project and its specifics. These constitute the direct cost for the project. There are indirect costs as well. The indirect costs are legal fees, administrative costs, cost of technical assistance, and more. Since DIBs are a relatively new financial instrument, the indirect costs are usually higher.

Apart from these costs, development impact bond has non-monetary costs as well. These costs include the time that the project leader and key personnel give in overseeing the project. Another cost we can associate is the reputation cost, if the service provider is unable to successfully complete the project.

Final Words

DIBs are an innovative financial instrument that can help solve difficult issues. However, they are not fit for all projects. But, in cases they are applicable, they result in efficient outcomes, as well as create space for more innovation.  

References

https://dalberg.com/our-ideas/how-development-impact-bonds-work-and-when-use-them/

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Opposite of Risk Aversion https://efinancemanagement.com/investment-decisions/opposite-of-risk-aversion https://efinancemanagement.com/investment-decisions/opposite-of-risk-aversion#respond Wed, 10 Feb 2021 12:21:15 +0000 https://efinancemanagement.com/?p=39799 What is the Opposite of Risk Aversion? Risk aversion is an approach to making investments in safe and stable financial instruments, even though if they provide limited or low returns. Risk-averse investors choose instruments that provide maximum security to their investments. Such instruments will seldom vanish from the markets, or the companies offering them do ... Read more

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What is the Opposite of Risk Aversion?

Risk aversion is an approach to making investments in safe and stable financial instruments, even though if they provide limited or low returns. Risk-averse investors choose instruments that provide maximum security to their investments. Such instruments will seldom vanish from the markets, or the companies offering them do not pose a threat of running away. Also, there are little chances of a steep fall in the investment value. The flip side of this strategy is that the returns from such a portfolio will be low, limited to the market’s performance, and not very high or extraordinary. The opposite of risk aversion is “Risk Tolerance”.

Risk tolerance is a term that measures the quantum or the level of risk that an investor is willing to take and bear. A risk-tolerant investor has the ability to tolerate risks or face uncertain consequences of making investments. Hence, they can make investments in a bit more risky financial instruments with a view to earning more handsome profits. They have a long-term view of making higher profits even if they suffer a few losses in the short-run. Risk tolerance levels help managers and fund houses to design and shape investment portfolios of their clients. It is according to the risk tolerance levels that one should decide where, when and how much to invest. A less risk-tolerant investor should go for low-risk investments whereas a high risk-tolerant investor should go for high-risk instruments.

Factors affecting Risk Tolerance?

One has to consider numerous factors while measuring or analyzing the risk tolerance level of an investor. Some of them are:

Risk Tolerance Impact by Investment Horizon

The investment horizon or time period that an investor has decides the risk tolerance level to a large extent. If an investor has a long-term horizon and plans to stay invested over a period of a few years, he can take a high risk-tolerant approach. On the other hand, if an investor plans to keep his investments for just a few months or a couple of years and wants a certain amount of return, he will take a less risk-tolerant approach. Thus, higher risks can be taken with a long-term horizon than a short-term horizon.

Age of the Investor

The age of an investor has a lot of impact on his risk tolerance levels. Prudence says the risk tolerance level of an investor decreases with the growing age, other things being constant. Hence, young investors can afford to take more risks than older investors. Young people by nature can bear market fluctuations better. Also, even if they suffer short-term losses, they have a long time ahead to cover their losses.

Portfolio Characteristics

A portfolio with financial goals of stability and security of investment will adopt a less risk-tolerant approach. On the other hand, investors with portfolio goals of quick and more returns will adopt a higher risk tolerance approach.

Also, risk tolerance levels will increase with the increase in the size of the portfolio. Bigger portfolios can afford to take higher risks in comparison with smaller portfolios. The bigger portfolios will not take many hits even if security or two give negative returns. Whereas in the case of smaller portfolios, this will not be the case. They will suffer when even one security gives negative returns and hence, they will adopt a low risk-tolerant approach.

Opposite of Risk Aversion

What are the Types of Risk Tolerance?

There are three main categories of investors on the basis of their risk tolerance levels.

Aggressive Investors

Aggressive investors aim for high returns from their investments within a short span of time. Thus they have high-risk tolerance levels. They are usually rich with an ability to invest substantially. Also, they have good information about the market.

The usual investments of such investors include equities, derivatives, and risky market instruments. They shy away from safe and low return investments such as bonds. Such investors earn handsome profits when the markets do well. Also, since the investments come with high risk, they suffer big losses at the time of poor performance of the market.

Moderate Risk Investors

Moderate risk-taking investors come after the aggressive investors in terms of the magnitude of risk they undertake in their investments. With lower risk comes lower but safer return expectations from the portfolio.

The investment portfolio of such investors comprises a mix of equities, derivatives, bonds, and ETFs. They have a small or negligible investment in the high-risk market instruments that can lead to heavy losses in times of poor market performance. Hence, their portfolios do not see large movements- both upwards and downwards.

Conservative Investors

Conservative investors take the least amount of risk while making their investment decisions. They go for safe and steady investments, even if the returns from them are marginal or limited. They totally avoid risky asset classes and instruments whose returns fluctuate a lot or are uncertain. Instead, they invest in very safe instruments such as government bonds, bond funds, and ETFs. Hence, their portfolio grows slowly and steadily, but with maximum protection and the least possible risk.

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International Banking Facility https://efinancemanagement.com/international-financial-management/banking-facility https://efinancemanagement.com/international-financial-management/banking-facility#respond Wed, 10 Feb 2021 06:10:59 +0000 https://efinancemanagement.com/?p=39722 What is International Banking Facility? International Banking Facility or IBF is a facility wherein the US Banking institutions provide banking services such as granting loans, accepting deposits, to foreign residents and foreign banks. Banks establish a separate account to provide these services, they, however, can conduct their IBF operations from their existing US-based offices. As ... Read more

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What is International Banking Facility?

International Banking Facility or IBF is a facility wherein the US Banking institutions provide banking services such as granting loans, accepting deposits, to foreign residents and foreign banks. Banks establish a separate account to provide these services, they, however, can conduct their IBF operations from their existing US-based offices. As banks establish a separate account for this service, the accounting for transactions under this facility is also separate from the domestic transactions.

Three Regulatory Developments have led to the Establishment and Structuring of IBFs.

  1. In July 1978, the New York Clearing House proposed the concept of IBFs. The concept was proposed to the Board of Governors in the Federal Reserve Board, citing the economic sense to the US out of it.
  2. In June 1981, the formation of IBFs got approval from the Board of Governors in the Federal Reserve.
  3. IN 1981, Federal legislation exempted IBFs from Insurance Coverage given by The Federal Deposit Insurance Corporation

What Advantages Accrue to the International Banking Facility?

IBF operations of a bank are free of the reserve requirements or the interest rate ceilings under the Federal Reserve System. This privilege, of not being bound by the reserve requirements set by the Federal Bank, was formerly available to only foreign banks. With this facility coming into play, it made it possible for the US financial entities to compete with foreign banks. And allowed the domestic institutions to attract and garner funds from foreign individuals and entities. This money could, otherwise, have gone to the foreign banks.  Many states in the US, therefore, encourage domestic banking institutions to set up IBF services. They do so by giving them tax benefits under their local laws. In Florida, for example, IBFs are completely exempt from local taxes.

International Banking Facility

The Federal Deposit Insurance Corporation (a Federal Agency that insures deposits in the US Banks), does not insure the deposits under IBFs. This means that the deposits under IBFs are at higher risk. Therefore, the IBF deposits attract a higher rate of interest.

IBFs can offer time deposits in large denominations to foreign residents. The minimum non-bank deposits and withdrawals at an IBF must be $1,00,000. IBFs can conduct business in foreign currency. Also, they can extend credit to other IBFs or the US offices of the IBF parent institution. The funds borrowed by a parent institution from its own IBF, however, are contingent on Euro currency reserve requirements.

Restrictions on International Banking Facility

In order to separate International Banking Facility from the domestic money market operations, there are four restrictions on their operations:

  1. IBFs can take deposits from and advance loans to only 3 entities: 1) A non-resident individual of the US 2) other IBFs 3) Parent institution of the IBF itself.
  2. The initial maturity date on a deposit by a foreign individual must be at least two working days. This is to ensure that IBFs do not create a substitute for checking accounts (a type of bank account that allows you unlimited deposits and withdrawals for daily transactions)
  3. The minimum number of non-bank transactions must be at least $1,00,000. This is to limit the operations of the IBFs to the wholesale money market (borrowing or lending money in large quantities, majorly done by governments, corporations, and large institutions)
  4. Under an International Banking Facility account, a bank cannot issue negotiable instruments. A negotiable instrument is an instrument duly issued/signed and stamped by the bank. Since the instrument is signed by the bank, it amounts to a guaranteed payment by the bank of the money involved in the instrument at a specific time or when the owner demands it. IBFs are not allowed to issue these instruments as they can be easily used in the US money market.
  5. IBFs cannot accept deposits and grant loans to the non-resident customer for the customer’s economic activities in the US. This is to ensure that IBFs do not compete with domestic sources of credit.

Location of IBF Centers

Of the nearly 500 International Banking Facility in existence, almost half of them are located in New York. Another big chunk of the remaining pie in California, Illinois, and Florida. What this uneven distribution of IBFs reflects is the locus of the international banking business. This distribution, however, can be due to differences in tax treatments accorded to IBFs by different states.

References

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Medium Term Note: Meaning, Risk, Types, Participants, Advantages, and More https://efinancemanagement.com/sources-of-finance/medium-term-note https://efinancemanagement.com/sources-of-finance/medium-term-note#respond Mon, 08 Feb 2021 13:29:51 +0000 https://efinancemanagement.com/?p=39751 Medium Term Note: Meaning A debt market instrument specifically a Note, which mostly matures between 5 years to 10 years is known as a Medium Term Note (MTN). And it is issued by the Companies for a continuous period, with varying maturities ranging from 5 years to 10 years. However, these days, government agencies, institutions, ... Read more

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Medium Term Note: Meaning

A debt market instrument specifically a Note, which mostly matures between 5 years to 10 years is known as a Medium Term Note (MTN). And it is issued by the Companies for a continuous period, with varying maturities ranging from 5 years to 10 years. However, these days, government agencies, institutions, banks, and countries also issue MTN. Medium-Term Notes act as a continuous source of finance for the companies. Although the duration of MTN is not strictly from 5 years to 10 years. And sometimes the duration can vary from 9 months to 30 long years as well.

MTN gives higher coupon rates in comparison to Short Term Notes and lower coupon rates in comparison to Long Term Notes. Moreover, Medium-Term Notes can be issued at a fixed interest rate, floating interest rate, zero-coupon, inverse floating rate, step-up/step down rate, etc, although they are mostly issued at a fixed interest rate. The interest rate can be compounding monthly, quarterly, semi-annually, or annually, depending on the issuing company. And the coupon rate can also be in any currency depending on the type of MTN.

Medium-Term Notes are mostly issued with two options, i.e. call option (also known as a callable note or redeemable note) and non-call option. MTN with call option allows the companies to call back the Notes before maturity. And companies in order to take benefit of lower rates, call back the higher rate MTN and later issues new MTN at lower rates. Thus MTN with call option allows the organizations to take advantage of lower interest rates. On the other hand, MTN with a non-call option does not allow the companies to redeem the notes before maturity. As a result, MTN with a call option provides higher coupon rates in comparison to MTN with the no-call option.

Understanding Medium Term Note

Dealers act as an intermediary between the issuing company and the investors. They offer MTN with varied maturity dates. These Dealers play a very important role in the market by acting as a connecting link and thereby facilitating the trade. Investors before investing in a Medium Term Note analyses various aspects like credit ratings of the company, business structure, and products of the company, the coupon rate of the note, the maturity of the note, interest rate, financial strength, and so on.

The issuing company of Medium Term Note has to submit various documents to the Securities Exchange Commission (SEC). Those documents are as follows:-

  1. A detailed prospectus
  2. A Universal Shelf Registration statement for debt securities and other types of securities
  3. Preliminary and Final Term Sheets
  4. Product Supplement
  5. Pricing Supplement
  6. Press Release

These documents are non-exhaustive in nature

Risk in Medium-Term Notes

Medium-Term Notes, as compared to the bonds are less risky in nature. According to the experts, almost 33% of the MTNs have full or partial protection on their principal amount. However, though these MTNs and partially protected, still their classification in the books of accounts of the issuing company remains as Unsecured Creditors.

Types of Medium Term Note

US Medium-Term Notes

On the basis of the location of issuance, there are two types of MTNs, i.e. US Medium Term Notes, and Euro Medium Term Notes. US MTNs are issued under the US Medium-Term Note Program, for the investors of the United States. The issuer has to submit a shelf registration and dully filled prospectus to the Securities Exchange Commission (SEC) of the USA.

Euro Medium-Term Notes

All those MTNs, which are traded in countries except the USA and Canada, are known as Euro Medium Term Notes. These MTNs have access to a wide market and trade takes place with varying maturities and varied currencies.

Asset-backed Medium-Term Notes

Medium-Term Notes which are backed by mortgages or any other assets are known as Asset-backed MTNs. Mostly MTNs do not have any asset backing and are solely issued on the basis of the creditworthiness of the issuing company.

Structured Medium Term Note

There are also Medium Term Notes which are linked to derivatives and are known as Structured Medium Term Notes. They serve the investing requirements of the investors and also reduce the risk level of the investor, thereby serving the purpose of both parties. There are also many types of Structured MTNs, like LIBOR Differential Note, Dual Currency MTN, Exchange Traded Notes, etc.

The financial community are always trying to come up with some innovative ways of raising funds. Hence, the classification and types of MTNs will always be dynamic.

Medium term notes

Participants in Medium Term Note Program

There are many participants, who play a vital role in the MTN issuance program.

Issuer

They are the main issuing body of the MTNs. They are the companies willing to access medium-term debt security by giving coupon rates in return.

Guarantor

Guarantors are not always participants in the MTN program. They are generally subsidiaries that give a guarantee when the credit rating of the issuing company is not sound enough. Guarantors mostly have higher credit ratings than the issuing company.

Intermediaries

There are intermediaries that enhances the MTN trade. These intermediaries are Arranger, Selling Agents, and Regional Dealers. They act as an intermediary between the issuer and the investor and make the trade successful.

Other Bodies

For other related work, there are several bodies that need to perform those specific tasks. Law firms scrutinize the legal obligations, Accounting firms conduct the process of auditing, and Credit Rating Agencies give credit ratings to the issuing company.

These intermediaries are non-exhaustive in nature.

Advantages of Medium Term Note

  • MTN acts as a continuous source of debt finance for the companies.
  • This instrument keeps enough cash flow in the organization and thereby enhances the growth of the company.
  • One of the biggest advantages of MTN is that it gives higher coupon rates as compared to Short Term Note.
  • MTN permits the issuing company to register itself under the Securities Exchange Commission (SEC) only once for all of its issues. This helps the companies in, abiding by the regulatory requirement in a hassle-free manner with lesser documentation.
  • Since MTN registration happens under Shelf Registration, it reduces the total issuing cost of the company.
  • This instrument serves the purpose of all those investors who are unwilling to invest for short or long durations. This debt instrument fits best to investors who give preference to medium-term investment.
  • Medium-Term Notes with call option allows the companies to initiate premature redemption if they have sufficient cash flows. It also permits them to take benefit of lesser interest rate, by reissuing the notes.
  • MTN reduces the risk of reinvesting funds at a lower interest rate in a shorter duration. Investors engage their funds for a comparatively large duration with a fixed interest rate under MTN.
  • Medium Term Note allows the investors to select maturity dates according to their time zone. It also allows them to select between the call option and the non-call option.
  • MTN helps the company in managing its asset-liability management (ALM).
  • Medium Term Note allows the issuing company to get funding in silence. Because for such issuance the company need not make public disclosure of its financial status.
  • MTN allows the investor to conduct a reverse inquiry if the investment product with its required characteristics is not available in the market.

These advantages are non-exhaustive in nature.

Medium-Term Notes Vs Bonds

One of the major differences between Bond and MTN is that issuance of Bonds happens only once while MTNs issuance happens on a continuous basis with varying maturities. Thus the funds mostly remain available with the company on a rolling basis. The target investors of Bonds are the general public at large and that of MTNs are HNIs (High Net Worth Individuals) and institutional investors. Bonds are riskier than MTNs. These differences are non-exhaustive in nature.

Conclusion

Medium-Term Notes (MTNs) are an important source of debt finance for the issuing body. Because of the flexible nature of the MTN, both the investor and the issuer prefer this instrument. It gives higher coupon rates in comparison to other short term investments and comes up with varying maturities. The callable nature of MTN gives the issuing company to take advantage of lower interest rates. Thus it is one of the very important, debt instruments.

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