Foreign Currency Swap or Foreign Exchange Swap

Each entity has a different access and different needs in the international financial markets. Companies receive more favorable credit ratings in their country of domicile than in the country in which they need to raise capital. Investors are likely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency. Currency swaps are also used to lower the risk of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management.

A currency swap transaction involves an exchange of a major currency against the U.S. dollar. In order to swap two other non- U.S. currencies, a dealer may need to arrange two separate swaps. Although, any currency can be used in swaps, many counter-parties are unable to exchange their currencies due to a lack of demand. Since currency swaps involve die exchange of two or more types of currencies, the actual exchange of principals takes place at the commencement and the termination of the swaps. On certain occasions, the exchange occurs only at the inception of the swap depending on the nature of the swap. The exchange of principals is necessary because of the fluctuation of currencies. Also, counter parties may need to utilize the respective exchanged currencies. Principals and interest payments are exchanged based on the spot rate agreed at the inception of the swaps.… Read the rest

Separate Trading of Registered Interest and Principal of Securities (STRIPS)

STRIPS is the acronym for Separate Trading of Registered Interest and Principal of Securities. STRIPS let investors hold and trade the individual interest and principal components  (also known as stripping) of eligible Treasury notes and bonds as separate securities.

The origin of Strip Bonds can be traced to the 1960s, when Investment Dealers in the United States began (physically) clipping coupons from bearer government bonds and selling the individual pieces as separate securities. These clipped bonds gained immense popularity and their sales gained momentum in the early and mid 1980s as the interest rates surged to high levels. This was so because it allowed investors to lock in the very high yields that were available at that time, without worrying about the risk of not being able to re-invest future interest payments at the same high rates.

The interest and principal steam of cash flow are deterministic and are known in advance. These are sold at their present values as deep discount bonds. The principal only (PO) and interest only (IO) segments represent two synthetic instruments that are excellent hedging instruments. By investing in various combinations, investors can create their own risk-return profile, something not enabled by holding plain-vanilla puts. The strip reacts differently to changes in interest rate behavior. The price movements of strips are impacted the repayment effect, discounting effect and their combined effect.

In the case of  principal only (PO), a fall in market interest rates would induce mortgage borrowers to prepay existing loans and borrow a fresh at lower rates.… Read the rest

Major Participants in Securitization Process

Securitization is the process whereby relatively illiquid financial assets such as mortgages are packaged together and sold off to individual investors. Securitization turns relatively illiquid instruments into quite liquid investments called asset-backed securities. A market maker agrees to create a secondary market by buying and selling the securities. Securitization originated in the mortgage market in the early 1980s, when mortgage loans began to be packaged together and sold off as securities in the secondary market often with government insurance guaranteeing that the principal and interest would be repaid. Securitization became popular because it provides a way of protecting against interest rate risk in an environment of increased interest rate volatility. Securitization offers reduced credit risk because of the pooling of assets.

Read More:

  • The Concept of Securitization
  • Process of Securitization
  • Benefits of Securitization

The securitization process involves a number of participants. The role of major participants in securitization process are given below.

1. Originator

The party behind a securitization is the originator. This entity generates (originates) or owns the defined or identifiable cash flow (that is, an income stream from receivables). An example of an originator with assets that can be securitized is a retail bank. Following assets are typically securitized: mortgages, automobile loans, credit card receivables, trade receivables, educational loans, etc. Securitized assets often have some or all of the following features: (i) large pool that permits diversification; (ii) low default rate; (iii) insensitivity to interest rate change; (iv) limited prepayment risk; (v) short maturity; and (vi) relatively homogeneous pools.… Read the rest

Benefits of Securitization

Securitization, also known as asset-backed securitization or structured financing, has been defined as a financing instrument whereby a company transfers rights in current or future receivables or other financial assets to an entity that serves as a “special purpose vehicle” (SPV), which in turn issues securities to capital market investors and uses the proceeds from the issue to pay for the financial assets. The source of the receivables could be any right of payment or asset that generates an income with a stable cash flow. The existing or future receivables could be the income generated, among others things by residential or commercial loans, credit card receivables, automobile loans, student loans, royalties on intellectual property, tax receivables or any other income source that is regular and predictable.

Read More: The Concept of Securitization

Securitization can also be considered a form of arbitrage between a less-efficient traditional debt market and a more-efficient capital market where old securities are dressed up as new asset-backed securities by financial firms for profit. Therefore, the slicing and dicing of cash flows and credit risks of the underlying pools of assets into securitized products with varying risk/return profiles and maturity spectra, and the spreading of risk among wider classes, serves the interest of consumers, borrowers, and the nation at large.

Read More: Process of Securitization

Major benefits of securitization as follows:

1. Cheaper Financing

By using securitization techniques to separate a pool of underlying receivables, the originator may be able to generate a lower cost of financing than it can through various forms of borrowing.… Read the rest

Steps Involved in the Process of Securitization

Securitization, a process by which illiquid financial assets are transformed into tradable commodities, is one of the most significant innovations of the financial world. Having originated in 1970 in mortgage markets in the USA, securitization has already converted over $90 trillion worth of non-tradable assets into marketable securities. As a powerful tool of liquidity and risk management, securitization has had a tremendous impact on the welfare of the world economy. In mortgage markets in many countries it provides a cheaper source of financing, and thus promotes the demand for housing. In the banking sector, securitization is widely used for allocating capital more efficiently, transforming risk into a tradable security, and reducing the overall cost of capital. It has enabled developing countries to emerging market institutions to raise their sovereign ratings ceilings and thereby tap international capital markets for lower-rate financing.

Read More: The Concept of Securitization

The process of securitization typically characterized by the following steps:

  • Identification Process: The lending financial institution either a bank or any other institution for that matter which decides to go in for securitization of its assets is called the ‘originator’. The originator might have got assets comprising of a variety of receivables like commercial mortgages, lease receivables, hire purchase receivables etc. The originator has to pick up a pool of assets of homogeneous nature, considering the maturities, interest rates involved frequency of repayments and marketability. This process of selecting a pool of loans and receivable from the asset portfolios for securitization is called ‘identification processes.
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Emerging Trends in International Capital Markets

Three interrelated developments in global capital markets are:

  1. The sustained rise in gross capital flows relative to net flows;
  2. The increasing importance of securitized forms of capital flows; and
  3. The growing concentration of financial institutions and financial markets.

Taken together these trends may signal what some others have referred to as a ‘quiet opening’ of the capital account of the balance of payments, which is resulting in the development, strengthening and growing integration of domestic financial systems within the international financial system. Finance is being rationalized across national borders, resulting in a breakdown in many countries in the distinction between onshore and offshore finance. It is particularly evident and most advanced in the wholesale side of the financial industry, and is becoming increasingly apparent in the retail side as well.

Taken together these three effects have contributed to a sharp rise in volatility – in both capital flows and asset prices – which may be characterized as periods of turbulence interspersed with periods of relative tranquility. Investor behavior (the supply of international capital) is a critical reason behind the rise in volatility. These broad trends have some important implications for the ongoing development of capital markets and institutions, including those in developing countries.

1. The Sharp Rise in Gross Capital Flows

The evidence points to an acceleration of capital account opening in most regions of the world since the late 1980s. The effects of opening in the formal sense of liberalizing transaction taxes and regulatory and legal restrictions on capital movements have been augmented by the liberalization of domestic financial sectors and by technologically induced reductions in transaction costs.… Read the rest