Financial Instruments

Priya Tiku MBA-Finance

Convertible Debentures
Convertible debentures are the type of debentures issued by the company which can be converted into a fixed number of ordinary shares after a predetermined period of time. By adding the convertibility feature, the owner issues a lower interest rate than without it.

Convertible Debentures
Promises a fixed income associated with debenture as well as a chance of capital gains associated with equity shares after the owner exercises the conversion option. Due to combination of fixed income and capital gains- HYBRID SECURITY.

Characteristics
Conversion ratio It is the number of ordinary shares per convertible security.
Conversion ratio = Par value of convertible debenture/conversion price

Conversion price It is the price paid for the ordinary share at the time of conversion.

 Conversion value signifies money worth of convertible debentures if it is converted into shares right now.
Conversion value = conversion ratio x share price

Advantages
Sweetening effect
lower interest cost. feature of convertibility gives the sweetening effect.

Deferred equity financing

by issuing a convertible debenture, the firm is, in effect, selling ordinary shares in the future.

Avoiding earnings dilution

It helps to avoid immediate dilution of EPS

 When money is tight and stock prices are growing, even very credit-worthy companies will issue convertible securities in an effort to reduce their cost of obtaining scarce capital. Most issuers hope that if the price of their stocks rise, the debentures will be converted to common stock at a price that is higher than the current common stock price. By this logic, the convertible debentures allows the issuer to sell common stock indirectly at a price higher than the current price.

Disadvantages
Risk of diluting EPS and control of the company. use of fixed-income securities magnifies losses to the common stockholders whenever sales and earnings decline; this is the unfavorable aspect of financial leverage. The indenture provisions (restrictive covenants) on a convertible bond are generally much more stringent than they are either in a short-term credit agreement or for common or preferred stock.

Repo/reverse repo
A repo or repurchase agreement is the simultaneous sale and repurchase of a security for different settlement dates. Reverse is simultaneous purchase and sale of a security for different settlement dates. Repo and reverses are 2 sides of the same transactions.

 Repos and reverses ---short term loans collateralized by underlying security. Used for short term funding, to invest short term cash balances, and to obtain securities for use in short sales. Originated in the US government securities. Earlier underlying securities used were T-bills and T-notes.

Repo
secure the funds pay for the security receive security

Reverse Repo
buy the bond immediately repo it out secure funds pay for the bond

 The motivation of the selling dealer is the short term loan it receives at a very low interest rate. Repos can be overnight repos. A repo for 30 days or more is called as a term repo.

 In a repo deal, the lender of the security is transferring the title for a short period of time. But the original owner is keeping the risk and return associated with the security. E.g. during the term of repo, markets might crash, the borrower of the security then has the right to demand additional collateral and vice versa.

 Coupon or dividend payments during the term of the repo are passed on to the original owner. This is called as manufactured dividend, and can occur at the end of the repo deal or some time during the repo term. The legal title of the repo passes on to the borrower, so that in case of default, the security automatically belongs to the borrower.

Advantages
A repo provides double security when lending cash. These are the (high) credit rating of a repo dealer and the collateral. A special repo is a unique and convenient way to enhance returns. By using repo markets, traders can short the market and raise funds efficiently. This improves general market trading and efficiency.

References
Books: Financial engineering John.F.Marshall, Vipul K Bansal Principles of financial engineering- Salih N.Neftci Financial Management, Ninth Edition- I M Pandey Websites: www.investopedia.com www.mysmp.com

THANK YOU