Total Return Swaps (TRS)

Total Return Swaps (TRS), sometimes known as a total rate of return swaps or TR swaps, are an on off-balance sheet transaction for the party who pays total returns composed of capital gains or losses plus the ordinary coupon or dividend, and receives LIBOR plus spread related to the counterparty’s credit riskiness on a given notional principal. The bank paying total returns is effectively warehousing, renting out its balance sheet while transferring economic value and risk to preferably an uncorrelated counterparty to the referenced assets. A TRS is similar to a plain vanilla swap except the deal is structured such that the total return (cash flows plus capital appreciation/depreciation) is exchanged, rather than just the cash flows. It is  one of the principal instruments used by banks and other financial instruments to manage their credit risk exposure, and as such is a credit derivative. They are used as credit risk management tools, and also as synthetic repo instruments for funding purposes. For example, a bank that keeps a huge book of loans may want to reduce its economic exposure to some of its loans while keeping the relationship with its customers who have the loans. The bank can enter into a total return swap with a counterparty that desires to gain economic exposure to the high yield loan market.

A key feature of a TRS is that the parties do not transfer actual ownership of the assets, as occurs in a repo transaction.  This allows greater flexibility and reduced up-front capital to execute a valuable trade. … Read the rest

Future Flow Securitization

Securitization of the future flow-backed receivables is a new phenomenon in developing economies. Future Flow Securitization has grown in emerging markets in response to finding lower cost funding instrument by investment grade firms in the emerging market economies where their abilities were hampered by sovereign rate ceiling. While many of these companies historically relied on bank loans, or straight debts syndicated by major foreign banks in the past, rising volatility of interest rates and foreign exchange rates as well as reduced risk tolerance of major lenders have pushed these institutions (sovereign and private companies) toward an alternative vehicle such as future flow securitization. Future flows, have successfully mitigated a variety of the risks associated with emerging-market investments, and consistently remained the most viable type of rated transactions for funding in emerging-market countries.

Future Flow Securitization Model

Future Flow Securitization involves the borrowing entity to sell future receivables that would have been generated by selling future products directly or indirectly to an off-shore facility known as Special Purpose Vehicle (SPV). The SPV sells asset-backed securities in the global financial markets and channels the funds generated from the sale of securities back to the originating firm. The essence of these transactions is to capture cash flows generated by a sovereign or private company by placing foreign investors on the underlying pool of collaterals in a senior position, legally and practically.

The cash flows from future flow transactions come from a variety of sources to an off shore facility, including foreign importers making payments on receivables, international credit card companies such as Visa, Master Card, American Express and other specialty cards by making settlement payments to local banks and international banks making remittance transfers to local banks.… Read the rest

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

Emerging Markets for International Capital Investments

Of late emerging markets have become a buzzword among the international investors for reaping greatest potential rewards which would be impossible if they stayed put in their affluent hinterlands. The term emerging markets (EMs) is a collective reference to the stock markets of the developing nations.  A question, which overpowers a discerning mind, is why the international investors are looking towards emerging markets for investing their funds instead of established markets like US? Three reasons can be given to answer this question.

First, the average total return of emerging markets has outstripped those of developed markets. Investments total return index computed by the IFC (International Finance Corporation) which measures the total return for each country based on those stock available to foreign investors shows that return on investment in IFC composite of EMs is 61.64 per cent higher than the return on investment in US market over the years. The institutional investors like the corporate pension funds; insurance companies and international mutual funds are looking towards investments in EMs to magnify their earnings.

Secondly the emerging markets provide excellent scope for diversification, as their correlation with the US and other developed markets is often exceptionally low. The EMs has low correlations not only with the developed markets, but also with each other. The fact that EMs (individually and as a group) has low correlations with the developed markets implies that there is an opportunity for diversification for the global investor.

Thirdly as the emerging markets are generally inefficient markets, the opportunity of finding bargain stocks increase for the highly knowledgeable money managers. … Read the rest

Syndicated Euro Credits

History of Syndicated Euro Credits

Syndicated Euro Credits are in existence since the late 1960s. The first syndicate was organized by Bankers Trust in an effort to arrange a large credit for Austria. During the early seventies, Euromarkets saw the demand for Euro credits increasing from non-traditional and hitherto untested borrowers. The period after first oil crisis was marked by a boom phase. To cope with the increasing demand for funds, lenders expanded their business without undertaking due credit appraisal of their clients or the countries thus financed. Further, the European banks had short-term deposits while bulk of borrowers required long-term deposits. These landings were at fixed rates thus exposing these banks to interest rate risks. The banks evolved the concept of lending funds for medium longterm i.e. 7-15 years on a variable interest rate basis linked to the  Interbank Rate (LIBOR). Revision of rates would take place every 3-6 months. These loans are extended in currencies denominated by US Dollar, Yen and Euro.  Amortization of the loan would be by way of half-yearly installments on completion of 2-3 years of grace period. At present, this instrument on a variable interest rate basis has emerged as one of the most notable and popular financing instruments in the international financial markets. Syndicated Credit remains as the simplest way for different types of borrowers to raise forex finance.

Types of Syndicated Euro Credits

Syndicated Euro Credits are classified into two types – club loans and syndicated loans. The club loan is a private arrangement between lending bank and a borrower. … Read the rest

Types of Foreign Bonds

Yankee Bonds

Yankee Bonds are US dollar denominated issues by foreign borrowers (usually foreign governments or entities, supranationals and highly rated corporate borrowers) in the US bond markets. Yankee bond has certain peculiar features associated with the US domestic market. SEC regulates the international bond issues and requires complete disclosure documents in detail than the prospectus used in Eurobond issues. Foreign borrower will have to adopt the US accounting practices and the US credit rating agencies will have to provide rating for these bonds. These bonds are sponsored by a US domestic underwriting syndicate and require SEBI (Securities and Exchange Board of India) registration prior to selling them in the domestic US market. Reliance Industries Ltd. has been the most successful corporate to tap this instrument with a 50-year, $50 million Yankee Bond issue.

Samurai Bonds

These are bonds issued by non-Japanese borrowers in the domestic Japanese markets. Borrowers are supranationals and have at least a minimum investment grade rating (A rated). The maturities range between 3-20 years. The priority for allowing issuance of Samurai bonds is given to the sovereigns after the supranationals and their entities and to high quality private corporations specifically if there are Japanese trade links. This is also a registered bond and the settlement and administrative procedures make it relatively costly. Among the Yen financing instruments, this instrument is the most expensive in terms of issuing costs. As this instrument is issued for the public, the arrangements for underwriting and selling have to be made which involves large documentation. … Read the rest