New Financial

Innovations
P.C.T.E.)
GDR
A bank certificate issued in more than one
country for shares in a foreign company. The
shares are held by a foreign branch of an
international bank. The shares trade as domestic
shares, but are offered for sale globally through
the various bank branches.
A financial instrument used by private markets to
raise capital denominated in either U.S. dollars or
some other freely convertible currency.
For Example
A European investor wanting an exposure in Indian
securities could do so via two routes:-
1. Enter the Indian stock market and buy the cos.
Stock on one of the Indian markets. But this
would also expose the investor to exchange risks
and statutory rules and regulations governing
purchase and sale of securities in the Indian
market.
2. Through GDRs which would give investors
ownership of the Indian company’s stock
without being subject to Indian stock market
regulations to a great extent.
Exchanges
The exchanges on which the GDR trades are chosen
by the company. Currently, the stock exchanges
trading GDRs are the:
London Stock Exchange,
Luxembourg Stock Exchange,
Dubai International Financial Exchange (DIFX),
Singapore Stock Exchange,
Hong Kong Stock Exchange.
GDR as financial instrument
Depositary Bank
Deposit agreement
Custodian bank
Advantages to an Investor
It allows investors to invest in foreign country
without worrying about foreign trading practices.
Easier trading.
Eliminates custody charges.
Payment of dividend in the GDR currency.
Institutional investors can buy them, even when
they may be restricted by law or investment
objective from buying shares of foreign
companies.
Eliminates local and transfer taxes.
GDRs are liquid because the supply and demand can
be regulated by creating or canceling GDR shares.
Advantages to an Issuing Company
Access to capital markets outside the home
market to provide a mechanism for raising capital
or as a vehicle for an acquisition.
Enhancement of company visibility by
enhancement of image of the company’s products,
services or financial instruments in a marketplace
outside its home country.
Expanded shareholder base which may increase
or stabilize the share price.
Adjust share price to trading market comparables
through ratios.
Enhance shareholders communications and
enable employees to invest in the parent
company.
They have also been used to raise capital in the
process of acquisition of other companies by the
issuer.
American Depository Receipts
Definition:-
An ADR is a dollar denominated negotiable
certificate that represents a non-US company’s
publicly traded equity.

ADRs enable U.S. investors to buy shares in

foreign companies without the hazards or
inconveniences of cross-border & cross-currency
transactions.
Types of American Depository Receipts

Unsponsored ADR programme.

Sponsored ADR programs

- ADR programme level 1
- ADR programme level 2
- ADR programme level 3

Rule 144 (A) ADRs.

Unsponsored ADR programme
What Does Unsponsored ADR Mean?

An American depositary receipt (ADR) that is

issued without the involvement of the foreign
company whose stock underlies the ADR.
Shareholder benefits, voting rights and other
attached rights may not be extended to the
holders of these particular securities.
Unsponsored shares are a form of Level I ADRs
that trade on the over-the-counter market.

These shares are issued in accordance with

market demand, and the foreign company has no
formal agreement with a depositary bank.

Unsponsored ADRs are often issued by more than

one depositary bank.
Sponsored ADR programme

An ADR which is issued with the cooperation of the

company whose stock will underlie the ADR. These shares
carry all the rights of the common share, such as voting
rights. ADRs must be sponsored to be able to trade on the
NYSE.
Level 1 depositary receipts
 Level 1 depositary receipts are the lowest level of sponsored ADRs that
can be issued.
 When a company issues sponsored ADRs, it has one designated
depositary who also acts as its transfer agent.
 A majority of American depositary receipt programs currently trading
are issued through a Level 1 program. This is the most convenient way
for a foreign company to have its equity traded in the United States.
 Level 1 shares can only be traded on the OTC market and the
company has minimal reporting requirements with the U.S. Securities
and Exchange Commission (SEC).
 Companies with shares trading under a Level 1 program may decide to
upgrade their program to a Level 2 or Level 3 program for better
exposure in the United States markets.
Level 2 depositary receipt
 Level 2 depositary receipt programs are more complicated for a
foreign company.

 When a foreign company wants to set up a Level 2 program, it must

file a registration statement with the US SEC and is under SEC
regulation.

 The advantage that the company has by upgrading their program to

Level 2 is that the shares can be listed on a U.S. stock exchange. These
exchanges include the New York Stock Exchange (NYSE), NASDAQ,
and the American Stock Exchange (AMEX).

 While listed on these exchanges, the company must meet the

exchange’s listing requirements. If it fails to do so, it may be delisted
and forced to downgrade its ADR program.
A Level 3 program
 A Level 3 American Depositary Receipt program is the highest level a
foreign company can sponsor.

 The company is required to adhere to stricter rules that are similar to

those followed by U.S. companies.

 Setting up a Level 3 program means that the foreign company is not

only taking steps to permit shares from its home market to be
deposited into an ADR program and traded in the U.S.; it is actually
issuing shares to raise capital.

 Foreign companies with Level 3 programs will often issue materials

that are more informative and are more accommodating to their U.S.
shareholders because they rely on them for capital. Overall, foreign
companies with a Level 3 program set up are the easiest on which to
find information.
Restricted programs
 Foreign companies that want their stock to be limited to being traded
by only certain individuals may set up a restricted program.

 There are two SEC rules that allow this type of issuance of shares in
the U.S.: Rule 144-A and Regulation S. ADR programs.
 144-A

 Some foreign companies will set up an ADR program under SEC Rule

144(a). This provision makes the issuance of shares a private
placement. Shares of companies registered under Rule 144-A are
restricted stock and may only be issued to or traded by Qualified
Institutional Buyers (QIBs). NYSE

 US public shareholders are generally not permitted to invest in these

ADR programs, and most are held exclusively through the Depository
Trust & Clearing Corporation, so there is often very little information
on these companies.
Regulation S

The other way to restrict the trading of depositary shares

to US public investors is to issue them under the terms
of SEC Regulation S. This regulation means that the shares
are not, and will not be registered with any United States
securities regulation authority.

Regulation S shares cannot be held or traded by any “U.S.

Person” as defined by SEC Regulation S rules. The shares
are registered and issued to offshore, non-US residents.

Regulation S ADRs can be merged into a Level 1 program

after the restriction period has expired, and the foreign
issuer elects to do this.
Meaning of Foreign Exchange Risk
Foreign exchange risk is the possibility of gain or loss
to a firm that occurs due to unanticipated changes in
exchange rate .
Types of Foreign Exchange Risk
Translation Risk

Transaction Risk

Economic Risk
Translation Risk
It is the degree to which a firm’s foreign currency
dominated financial statements are affected by
exchange rate changes
So, it is only for recording and maintaining he books
and not for actual profit or loss figure.
Transaction Risk
It is refers to the extent to which the future value
of a firm’s domestic cash flow is affected by
exchange rate fluctuations.

E.g.- In case of import and export, when we deal in

foreign currency. If dollar rate is Rs. 46 at the time
of contract and Rs. 49 at the time of payment.
Then this Rs. 3 per dollar is risk, and directly
recorded in balance sheet.
Economic Risk

It is refers to the degree to which firm’s present

value of future cash flows can be influenced by
exchange rate fluctuations.

Ex. Price of raw material from abroad and local

market is 48 and 46 per dollar respectively. If at
the time of payment dollar is Rs. 44 then
ultimately, we get more benefit on basis of
exchange rate gain.
Managing Transaction Exposure
Forward market hedge
Money market hedge
Here buying and lending takes place and the benefits is
sleeked on interest rates.
Managing Economic Exposure
Market Strategies

Market selection
Pricing strategies
Promotion strategies
Product strategies
Production strategies

Input mix
Shifting production plant
Raise in production
Tools for Transaction Exposure
Forward or Future hedge for payable

Money Market hedge

Swaps

Option hedge
Call option
Put option
Forward and Future hedge

Forward and future hedge allows an MNC to lock in the

specific exchange rate at which it can purchase a specific
currency and therefore allows it to hedge the payables
denominated in the foreign currency.

The contract will include:

 currency that the firm will pay
 currency that the firm shall receive
 amount of the currency
 rate at which the MNC will exchange the currency
 future date at which the exchange will take place.
Example of using futures contract with a bank:

 First, let’s assume that we sold merchandise to a British firm for 1 million
pounds payable in 6 months.
 One alternative is to go to our bank who, deals in foreign exchange, and
simply lock-in the value of the 1 million pounds sterling that we will receive in
six months with a forward contract with the bank.
 Assume that the forward rate that the bank offers to us is USD 1.5179 per
pound. Then, we are guaranteed that the amount we will receive will be the
following: Value of 1 million pound receivable = 1,000,000 pounds * USD 1.5179
per pound = USD 1,517,900
 What should be apparent, however, is that whether the pound appreciates or
depreciates, we’ve locked-in the amount that we will receive: USD 1,517,900.
Money Market Hedge
It involves taking a money market position to cover future
payables/recievables positon.

Borrowing and lending in multiple currencies, for example to

eliminate currency risk by locking in the value of a foreign
currency transaction in one's own country's currency.

MNCs prefer to hedge payables without using the cash

balances.

A money market hedge is to take the advantage of higher

interest rate prevailing in the other market.
For Example :
A U.S.–based importer of Italian bicycles

 In one year owes €100,000 to an Italian supplier.

 The spot exchange rate is $1.25 = €1.00
 The one-year interest rate in Italy is € = 4%

Can hedge this payable by buying €96,153.85 = €100,000/ 1.04

today and investing €96,153.85 at 4% in Italy for one year.

At maturity, he will have €100,000 = €96,153.85 × (1.04)

Dollar cost today = $120,192.31 = €96,153.85 ×$1.25/€1.00

To hedge a foreign currency payable, buy a bunch of that
foreign currency today and sit on it.

 Buy the present value of the foreign currency payable

today.

 Invest that amount at the foreign rate.

 At maturity your investment will have grown enough

to cover your foreign currency payable.
Option Hedge

An option is a contract that gives its owner the right but

not the obligation to buy or sell an underlined asset on or
before a given date at a fixed price.

Types :

Call Option (buy the currency)

Put Option (sell the currency)
Swaps
An exchange of streams of payments over time according to specified
terms.
The most common type is an interest rate swap, in which one party
agrees to pay a fixed interest rate in return for receiving a adjustable
rate from another party.

If companies in different countries have regional advantages on

interest rates, a swap will benefit both firms. For example, one firm
may have a lower fixed interest rate while another has access to a
lower floating interest rate. To take advantage of this situation, the
companies would do an interest rate swap.
What Risk Management Products do
Firms Use?

Most firms meet their exchange risk management needs

with forward, swap, and options contracts.

The greater the degree of international involvement, the

greater the firm’s use of foreign exchange risk
management.