Global Securities Operations Ed19 PDF

Investment Operations Certificate Global Securities Operations Edition 19, May 2023 This learning manual relates to syllabus version 18.0 and will cover examinations from 21 August 2023 to 20 August 2024 Welcome to the Chartered Institute for Se...

Investment Operations Certificate Global Securities Operations Edition 19, May 2023 This learning manual relates to syllabus version 18.0 and will cover examinations from 21 August 2023 to 20 August 2024 Welcome to the Chartered Institute for Securities & Investment’s Global Securities Operations study material. This workbook has been written to prepare you for the Chartered Institute for Securities & Investment’s Global Securities Operations examination. Published by: Chartered Institute for Securities & Investment © Chartered Institute for Securities & Investment 2023 20 Fenchurch Street, London EC3M 3BY, United Kingdom Tel: +44 20 7645 0600 Fax: +44 20 7645 0601 Email: [email protected] www.cisi.org/qualifications Author: Kevin Petley, Chartered FCSI Reviewers: Stephen Lacey, Chartered MCSI Henrietta Wu This is an educational workbook only and the Chartered Institute for Securities & Investment accepts no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland. A learning map, which contains the full syllabus, appears at the end of this workbook. The syllabus can also be viewed at cisi.org and is also available by contacting the Customer Support Centre on +44 20 7645 0777. Please note that the examination is based upon the syllabus. Candidates are reminded to check the Candidate Update area details (cisi.org/candidateupdate) on a regular basis for updates as a result of industry change(s) that could affect their examination. The questions contained in this workbook are designed as an aid to revision of different areas of the syllabus and to help you consolidate your learning chapter by chapter. Workbook version: 19.1 (May 2023) ii Important – Keep Informed on Changes to this Workbook and Examination Dates Changes in industry practice, economic conditions, legislation/regulations, technology and various other factors mean that practitioners must ensure that their knowledge is up to date. At the time of publication, the content of this workbook is approved as suitable for examinations taken during the period specified. However, changes affecting the industry may either prompt or postpone the publication of an updated version. It should be noted that the current version of a workbook will always supersede the content of those issued previously. Keep informed on the publication of new workbooks and any changes to examination dates by regularly checking the CISI’s website: cisi.org/candidateupdate. 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The CISI has more than 40,000 members, and nearly half of them have already completed relevant qualifications and transferred to a core membership grade. You will find more information about the next steps for this at the end of this workbook. iii iv Securities............................................................. 1 1 Main Industry Participants............................................. 69 2 Settlement Characteristics............................................. 111 3 Other Investor Services................................................ 151 4 Aspects of Taxation................................................... 191 5 Risk.................................................................. 207 6 Glossary.............................................................. 235 Multiple Choice Questions............................................ 251 Syllabus Learning Map................................................ 269 It is estimated that this manual will require approximately 80 hours of study time. What next? See the back of this book for details of CISI membership. Need more support to pass your exam? See our section on Accredited Training Partners. Want to leave feedback? Please email your comments to [email protected] v vi  Before you open Chapter 1 We love a book!...but don’t forget you have been sent a link to an ebook, which gives you a range of tools to help you study for this qualification Depending on the individual subject being studied and your device, your ebook may include features such as: Watch video clips Read aloud A A Adjustable text size allows Pop-up definitions related to your function* you to read comfortably syllabus on any device* Highlight, bookmark Images, tables and Links to relevant End of chapter questions and make animated graphs websites and interactive multiple annotations digitally* choice questions * These features are device dependent. Please consult your manufacturers guidelines for compatibility The use of online videos and voice functions allowed me to study at home and on the go, which helped me make more use of my time. I would recommend this as a study aid as it accommodates a variety of learning styles. Find out more at cisi.org/ebooks Billy Snowdon, Team Leader, Brewin Dolphin ebook bw 18.indd 1 02/10/2018 12:01:33 Chapter One Securities 1. Securities Investment 3 2. Shares (Equities) 6 3. Debt Instruments 11 4. Warrants 24 5. Depositary Receipts (DRs) 29 6. Collective Investment Vehicles 33 7. Securities Identification Numbers 41 8. Issue Methods in the UK 44 9. Principles of Trading 51 10. Exchange-Traded and Over-The-Counter (OTC) Transactions 54 11. Order-Driven and Quote-Driven Markets 56 12. Programme and Algorithmic Trading 60 13. Multi-Listed Shares 63 This syllabus area will provide approximately 11 of the 50 examination questions 2  Loans Securities 1. Securities Investment 1 Companies periodically need to raise funds to finance new developments in their business. To do so, they have a range of options open to them. One method that a company can use to raise new money is to take out a loan from a bank. The company will subsequently be required to pay back the principal on the loan (ie, the sum initially borrowed), plus an agreed rate of interest, at an agreed date in the future. It may be cheaper, and more in keeping with the strategic objectives of the company, to raise these funds through the capital markets. Capital markets bring together companies looking for money with investors who have money to invest. Companies need development money to finance research, to buy new equipment, to take on and train new staff, to modernise their infrastructure and to finance the acquisition of other companies. To access this investment capital, companies may issue securities in the name of the company which they then sell to the investor community. One technique for doing so is for the company to issue and sell shares in the company, a strategy known as equity financing. A person who buys shares (a shareholder) becomes a part-owner of the company. In return for investing money in the company, the shareholder shares both in the risks borne by that company (in a limited way) and in the profits that it generates. Shares represent a security in the company and can be sold to other investors, either via a stock exchange (exchange-traded) or through direct communication between investors themselves or agents acting on their behalf, commonly known as over-the-counter (OTC) or off- exchange trading, or via multilateral trading facilities (MTFs) or systematic internalisers (SI). MTFs are like online marketplaces for trading financial instruments outside traditional exchanges. 3 SIs are firms that fulfill their clients' orders internally using their own inventories instead of going through external exchanges. Another way that a company can generate funds through the capital markets is to sell debt in the company by issuing bonds and other debt-related securities (debt instruments). In simple terms, the company (the issuer) issues an IOU that it sells to investors (the bondholders) in return for cash. These loans will typically be established for an agreed period of time and the issuer will repay (redeem) the loan on a specified date when the loan matures (the redemption date). However, the investor is not required to hold the IOU until it is repaid. If the investor wants to realise money before this point, they may sell this IOU to another investor. These loans may pay a fixed or variable rate of interest to the bondholders on agreed dates throughout the period of the loan. Governments, municipal authorities and other public bodies also borrow money to finance development projects (ie, to build schools, roads, hospitals) or to manage their daily running costs. These bodies may also issue bonds and other debt instruments to raise this finance (eg, government bonds, municipal bonds). However, since they are not companies, governmental bodies do not issue shares. Companies regularly employ investment banks to help them to issue equity and bonds that are carefully tailored to investors’ needs. Investment banks may also underwrite securities issues to ensure that the issuer is able to raise the amount of capital that it needs. In order to raise finance through the capital markets, the securities issue must be appealing to the investor community, offering an instrument that will be appropriate for the investors’ investment objectives and financial circumstances. Issuers are creating increasingly sophisticated types of financial instrument, designed to offer an attractive return at a level of risk that the investor is prepared to bear. 1.1 Why do Investors Buy Securities? The fundamental goal from an investor’s standpoint is to optimise the level of return generated from its investments at a level of risk that the investor is willing to accept. This risk/return balance is integral to the investment process. Commonly, investments that hold greater potential for generating sizeable returns also carry higher risk that the investment will lose money, or may need to be written off altogether. A number of factors make securities investments attractive: Superior performance – as a long-term investment, securities may deliver higher returns than holding money in a bank cash deposit account. However, securities are not guaranteed to outperform cash investments, and investors must make an informed decision about the projected rates of return that will be delivered by equities, fixed-income securities, property and other potential asset classes over the term of their investment. Diversification – investing in a diverse range of securities (eg, different types of equities issued by companies in different economic sectors and different markets, a spread of government and corporate debt instruments with different times to maturity), alongside other categories of investment (eg, property, precious metals, commodities and collectibles, such as fine art), allows the investor to spread risk across the investment portfolio. Because not all parts of the economy deliver the same level of performance at the same time, exposure to a range of different sectors enables the investor to diversify their investment risk, providing a broad spread of growth and income opportunities as the economy grows. Spreading risk further across a range of global markets adds increased diversity to the asset portfolio. Regulatory oversight – securities markets globally are usually closely regulated, affording protection to the investor against malpractice and systemic risk. 4  Securities Liquidity – the market in many securities is relatively liquid, meaning that a buyer can be found 1 without either delay or a significant effect on market price when the investor wishes to sell a security, and vice versa. If an investor feels that the market for certain securities is likely to move up or down, it is important that the investor can increase or reduce the size of their securities holdings without delay in response to these market trends. High volume, low relative costs – many securities trade in high volume in securities markets on a daily basis. Consequently, the costs of securities trading can be relatively low compared with trading in some other categories of investment. 1.2 Sources of Investment Return Equities and fixed-income products offer two principal avenues for generating return on investment: 1. Capital appreciation – if the price of the security rises, the investor has an opportunity to sell the asset in order to realise a profit. The principle of buying and selling securities is, in many ways, similar to buying and selling used cars, gold coins, or other tradeable items: the investor aims to buy securities at market price and later sell for a higher price in the hope that they will be able to realise a capital gain on their investment. If the company is generating strong profits, then the share price is likely to rise as demand for the stock increases. For example, if the investor buys 100 shares in a company called ABC Manufacturing Company at £0.80 per share, and later sells these shares when the price has risen to £1.60 per share, the investor will have realised a profit (or capital gain) of £80, ie, Capital gain = (100× 1.60) − (100× 0.80) = 160 − 80 = £80 2. Income payments – investors may be paid an income (ie, dividends or interest) on the securities that they have bought. Equities investors (ie, ordinary share­holders) may be entitled to a share of any profits that the company has made through a dividend payment that is approved at the company annual general meeting (AGM). Bondholders will usually be paid a fixed rate of interest (known as the coupon) at fixed intervals throughout the period of the loan. 1.3 Who Invests in Securities? For the sake of simplicity, we have referred so far to an individual investor who has purchased stocks and bonds in order to realise an income and a potential capital gain on their initial investment. However, pension schemes, life insurance companies, mutual funds and other institutional investors also invest widely in securities markets in order to generate returns on the investments that they hold on behalf of their members. Members and sponsors of pension funds, for example, will pay into the scheme throughout their working life and will expect to receive an income from the pension scheme on retirement. These monies will be invested by the pension scheme in a range of financial instruments, including equities and fixed -income instruments, to meet the liabilities that the pension scheme will have to pay to its members when they retire. When people work, they often contribute money to a pension fund. This is like saving for retirement. The pension fund invests this money in different things, like stocks and bonds, to grow the savings over time. When people retire, they expect to receive regular payments from the pension fund, kind of like a salary. These payments come from the returns earned on the investments made by the pension fund. For example, let's say John works for a company that offers a pension plan. Every month, a portion of his salary 5 goes into the pension fund. The pension fund then invests this money in various things, like company stocks and government bonds. Over the years, these investments grow in value. When John retires, he'll start receiving monthly payments from the pension fund, which come from the profits earned on the investments made with his contributions. This helps John have a steady income during his retirement years. Governments and sovereign wealth funds may also invest in international capital markets to optimise investment return and to provide a diversified portfolio of assets that will afford protection against movements in global markets. Investment management companies (often known also as asset managers or fund managers) will invest in securities markets, either: 1. to generate investment returns for investors (eg, private investors, pension funds) who have paid money into the funds that they manage, or 2. to generate returns on the company’s own account by investing its own money. This situation, where the investment company acts as principal for the invested funds, is known as a proprietary investment. Investment banks have traditionally been high-volume players in global securities markets, trading both as principal in order to generate investment returns on their own accounts, and as agency traders, placing trades on behalf of third-party clients. Investment banks historically have not catered directly for the retail investor, but have concentrated on providing services to corporations, governments and other financial institutions. In some cases, however, they may also provide investment services to wealthy private banking clients, often known as high-net worth individuals (HNWIs). Having provided a brief introduction to the world of securities investment, and to the functioning of capital markets, we will now look more closely at the characteristics of some of the broad range of securities available to the investor. 2. Shares (Equities) All listed companies issue ordinary shares, but some may also issue preference shares and deferred shares. 2.1 Ordinary Shares Learning Objective 1.1.1 Understand the characteristics of ordinary shares: ranking in liquidation; dividends; voting rights/non-voting shares; deferred shares; registration; bearer/unlisted securities E=A-L Equity is the residual value of a company’s assets after all its liabilities have been taken into account. The equity of a company is the property of the ordinary shareholders. Hence, ordinary shares are often known as equities. The money that a company raises by issuing ordinary shares and selling them to investors is called equity capital. 6  Securities Unlike debt capital, which is borrowed money, equity capital does not need to be repaid since it 1 represents continuous ownership of the company. In return for investing in the company, ordinary shareholders are part-owners of the company and have rights to: attend and vote at shareholder meetings, including the AGM and any extraordinary general meeting (EGM) receive the annual report and accounts share in the company’s profits by receiving a dividend paid on each share that the investor holds (although in some circumstances the directors may elect not to pay a dividend) participate in the appointment and removal of company directors share in the remaining assets of a company if it goes into liquidation receive a capitalisation, or bonus issue in proportion to their existing holdings participate in rights issues or other offers of new shares be consulted in special circumstances (eg, when a merger is proposed), and additional benefits, or perks (eg, eligible shareholders in a construction company may be offered a discount on the price of a new property, and eligible shareholders in a train company may be offered discounts on the price of rail travel – typically, the company will specify a minimum number of shares that must be held to qualify for these benefits). In some instances, a company may issue ordinary shares that do not carry voting rights (known as non- voting shares). Holders of this type of share will not be entitled to vote on company resolutions at any AGM or EGM. Deferred shares are part of the ordinary capital of a company and offer holders the same rights as ordinary shares, with the exception that they do not rank for a dividend until specified conditions are met, at which time they are then said to rank pari passu with the ordinary shares. For example, a dividend may not be paid until a specified date has been reached, or until the company has reached a specified level of profitability. In the context of deferred shares, "pari passu" means that once certain specified conditions are met, these shares will have the same rights and status as ordinary shares in terms of dividends. 2.1.1 Share Registration In the UK and many other major markets, the shareholder’s name and address will be recorded in the issuer’s register of shareholders. In the UK, the issuer register is in two parts: the physical share register, maintained by the issuer registrar, and the dematerialised part of the register maintained in the CREST system, the securities settlement system of Euroclear UK & International. CREST passes the dematerialised part of the register to the issuer registrar to ensure the registrar holds a complete copy of the register for public inspection. The dematerialised part of the register in CREST provides a legal record of title, representing the primary legal record determining share ownership (see chapter 2, section 3.3). Some countries place restrictions on the sale or transfer of certain categories of shares to non-resident investors (see section 2.1.4). In some jurisdictions, takeover regulations require that a shareholder makes an open offer to acquire shares from all remaining public shareholders when his/her holding reaches a specified threshold limit (eg, in the UK, this threshold is currently 30% of a company’s issued capital). CREST, which is a system for holding securities electronically, transfers the ownership records of dematerialized shares to the registrar of the company that issued the shares. This ensures that the registrar has a complete copy of the ownership records, which can be inspected by the public. For example, let's say you own shares of Company ABC, and these shares are held in electronic form through CREST. When you buy or sell these shares, the ownership records are updated in CREST. Periodically, CREST transfers these records to Company ABC's registrar, who maintains the official register of shareholders. This allows anyone to inspect the ownership records to see who owns shares in Company ABC. 7 2.1.2 Listing Listed securities are those that have been accepted for trading on a recognised investment exchange (RIE, a stock exchange or securities exchange offering listing services and trading in a range of securities and, in some cases, a selection of other instruments). To list their securities, issuing companies must, typically, fulfil conditions specified under the listing requirements of the RIE concerned. In the UK, the term ‘listed securities’ refers to securities which are: admitted to trading on a specified recognised investment exchange, and included in the official UK list maintained by the Financial Conduct Authority (FCA) (in its capacity as the UK Listing Authority) or are officially listed in a qualifying country outside of the UK in accordance with provisions corresponding to those generally applicable in European Economic Area (EEA) states. The listing process may offer a number of benefits to the issuer and the holder of the security: The security is traded in a regulated and orderly marketplace. The exchange can provide a liquid market for the security – those wishing to sell the security can find potential buyers, and vice versa. The exchange will provide regular reporting on sales and purchases of listed securities. Disposal of shares by company directors and associated persons must be publicly disclosed. Companies wishing to list on an RIE will typically be subject to a detailed investigation, designed to safeguard the integrity of the exchange and to offer a degree of protection to investors that they are buying securities in a bona fide company. Listing is also subject to regulatory approval. The liquid nature of exchange trading can facilitate price determination – typically, prices of listed securities will move up and down according to supply and demand across potential buyers and sellers active on the exchange. Unlisted securities are those that are not listed on an RIE. These securities will be traded off-exchange or over-the-counter (OTC) (see section 10 for further detail). A private placing (also known as a private placement) is an offer, usually by a wealth manager, of shares (or often bonds) to a selection of clients, both private and institutional, that is issued privately and not on the open market. Such instruments are not listed or traded on a trading venue. A company may use this method of fund raising as an alternative to an initial public offering (IPO). A private placing is subject to very few regulatory requirements or obligations. 2.1.3 Bearer Securities Historically, new issues of equity resulted in the issue of share certificates in the name of the shareholder. Some markets continue to issue and process certificated securities. If the security is unregistered, legal title will rest with the investor who physically holds the security (the bearer). This is known as a bearer security. A bearer security is a security where no registration of ownership is required and proof of ownership lies in physical possession of the security certificate, which will typically be held in safe custody with a specialist custodian bank (see chapter 2, section 2.1). The investor’s name does not appear on the security and, thus, anyone who presents the certificate has the right to receive the cash value. Dividends are normally claimed by detaching coupons from the certificate. 8  Securities Bearer securities are often used by Eurobond and other international issuers, but they are rarely seen 1 physically these days, due to the high risk of loss and/or misappropriation. Few UK companies issued bearer shares and, after a phasing-out period, they were abolished. The main reasons bearer shares were phased out were to improve transparency of ownership and because of drives to dematerialise shares. Such drives have been replicated across most jurisdictions. 2.1.4 Transfer Restrictions In some jurisdictions, and for certain securities, restrictions may be applied on how, and to who, securities may be transferred. For example: 1. In some instances, securities may not be sold to foreign investors, or foreign investors may be restricted from holding more than a specified percentage of the total issued capital in specified companies, or must report to the regulatory authorities, the exchange and/or the depository when the size of their holding exceeds a specified percentage of the total issued shares in a company. 2. In some circumstances, securities holders may be restricted from selling or transferring securities in quantities of less than 1,000, or some other specified block/lot size. 3. Restrictions may be placed on the transfer of securities when the issuer is subject to bankruptcy or legal proceedings. 4. Issuers in some jurisdictions may place restrictions on the transfer of securities for a given period after issuance, conversion or other form of change in status, without the issuer’s explicit consent. 2.2 Preference Shares Learning Objective 1.1.2 Understand the characteristics of preference shares: ranking in liquidation; dividends; voting rights/non-voting shares; cumulative/non-cumulative; participating; redeemable; convertible By issuing preference shares, companies may raise share capital without diluting the ownership rights of ordinary shareholders. Preference shares are part of the company’s total share capital, but do not represent part of the company’s equity share capital. Consequently, preference shareholders do not have a share in the rising profitability of the company. Characteristics of preference shares are: Preference shareholders have no voting rights. Preference shareholders are paid a fixed dividend per share, which is established at the time of issue and does not increase with rising profits of the company. 9  Example Consider the following preference share: 3% preference dividend £0.40. This is a preference share with a nominal value of £0.40 per share that carries a dividend of 3%. Hence, it will pay a dividend income of 3% of £0.40 every year for every share issued. If a company has issued 100,000 of these shares at nominal value then it will have received: 100,000 × 0.40 = £40,000 from shareholders on issue. It will pay a total annual dividend of: 40,000 × 3% = £1,200 each year. Preference shares do offer some important benefits over ordinary shares: Holders of preference shares take preference over the ordinary shareholders for dividend payments and payments following liquidation. If the company were to go into liquidation with sufficient funds available, preference shares will be repaid at nominal value (or par value, namely £0.40 in the example above) before any repayment is made to ordinary shareholders (see below). Payment of Obligations after Liquidation If a company goes into liquidation, or is wound up, the assets are generally sold and the proceeds will be paid out in the following order: 1. Senior secured debt (ex. first lien) 2. Secured debt (ex. second lien) 3. Senior unsecured debt 4. Unsecured/subordinated debt 5. Hybrid securities (such as convertible bonds and preference shares) 6. Ordinary shares *Please be aware that this ranking list is illustrative only, because in reality the debt structures of companies can be much more complicated. Preference shareholders may be entitled to a fixed dividend even when no dividend is paid to ordinary shareholders. A preference shareholder is not guaranteed a dividend every year, since the company may decide not to pay a dividend at all. However, if the company does decide to pay a dividend, preference shareholders have the right to receive their dividend before the ordinary shareholders in all circumstances – hence the term preference. Preference shares may be cumulative or non-cumulative. If a dividend is not paid, cumulative shareholders receive the dividend carried over, and the company must pay these shareholders before it can pay any other dividends. In the example above, if the £1,200 for 2023 is missed, then preference shareholders may receive £2,400 in 2024 (assuming the company is in a position to pay a dividend in 2024). Non-cumulative shareholders simply lose the dividend if it is not paid, as a normal shareholder would. 10  Securities A preference share may be redeemable, which means that, at some time in the future, the company will 1 buy it back. Redeemable shares usually look like this: 3% cumulative preference share of £0.40, 2025 This indicates that the £0.40 per share preference share carries an entitlement to a 3% dividend and will be redeemed in 2025. If a preference share is a participating preference share, then the shareholder has the right to participate in, or receive, additional dividends over and above the fixed percentage dividend discussed above. The additional dividend is usually paid in proportion to any ordinary dividend declared. Preference shares may be convertible. If the shares are convertible, then the shareholders have the option, at some stage, of converting them into ordinary shares. 3. Debt Instruments Learning Objective 1.1.5 Understand the characteristics of fixed-income instruments: corporate bonds; eurobonds; convertible bonds; government bonds; discount securities; floating-rate notes; coupon payment intervals; clean and dirty prices; mortgage backed securities; asset-backed securities; index linked bonds 1.1.6 Be able to calculate: coupons, accrued interest calculations (actual/actual, 30/360) Debt instruments are (generally) interest-bearing securities issued when a borrower wishes to raise a specified amount of cash in a specified currency. As with equities, an issuer (ie, a company, government or government agency) sells bonds to investors in order to raise capital. However, unlike with equities, the borrower promises to: repay the capital to the investor at an agreed date in the future (except in the case of perpetual or undated bonds), and make periodic interest payments (known as the coupon) to the investor throughout the loan period (except in the case of zero coupon bonds). Corporate bondholders (ie, holders of debt instruments issued by a company) typically bear a lower risk in the company than shareholders. Hence, in the long-term, returns on equities may be higher than on bonds (though bonds may outperform equities for more prolonged times during this period). This additional return generated on equities, compared with bonds, is known as the equity risk premium. 11 Bonds typically carry lower risk than equities because of the following factors: Bondholders have a prior claim on the company’s assets relative to shareholders. Hence, if the company goes into liquidation, shareholders will face a higher likelihood that they may lose their money than bondholders. The return that the bondholder will usually receive is fixed at the time of issue and will be predictable if the bond is held until the redemption date. Specifically, the bondholder will receive an interest payment at fixed intervals throughout the period of the loan and will be repaid the par value of the bond at maturity. In contrast, shares have no fixed maturity and the shareholder’s return will be dependent on the company’s profitability and a number of other factors. In lean years, the company may pay no dividend on ordinary shares. However, it will still be required to pay interest on bonds and other debt securities. Example As an example, take an investor who is prepared to lend £1,000 to a company for five years and assume that interest rates are 7% per annum. In return for that loan, the company issues the lender with a bond. The bond is a legal acknowledgement of the debt and, under the terms of the bond, the company makes a number of promises to the lender. The two main promises are as follows: To pay interest on the bond at 7% a year. This interest payment is called the coupon and, in this case, will be 7% x £1,000 = £70 a year. To repay the capital of £1,000 in five years’ time. The repayment value of £1,000 is called the nominal value of the bond. Graphically, the cash flow will be as follows: Investor Maturity £1,000 Year 1 Year 2 Year 3 Year 4 Year 5 Issue Year 0 7% or £70 7% or £70 7% or £70 7% or £70 7% or £70 + £1,000 Bond Issuer 12  Securities From the perspective of a company issuing bonds: 1 bond issues typically allow the issuing company to obtain fixed-term finance at lower cost than it could via a bank loan bondholders do not represent part of the company’s equity share capital, so issuing bonds does not dilute the ownership of the company, and bondholders do not share in the rising profitability of the company, nor do they carry other corporate ownership privileges held by shareholders. The term coupon comes from the traditional feature of bond certificates where coupons were attached to the certificate. These were cut off and submitted to the company in order to claim interest entitlement. Most bonds are now dematerialised (that is, paper certificates have been eliminated and bonds are held and registered electronically, with transfer of legal title also taking place electronically) or immobilised (where the global certificate is held by a central depository and, again, transfers and legal title are registered electronically), but the term coupon is still used to denote the periodic interest payment. This statement explains how bond payments can The coupon rate is the rate of interest paid on the nominal value (also known as the face value, par value be made either with tax withheld (net payment) or redemption value) of the bond. or without tax withheld (gross payment), depending on the tax laws of the country. The coupon rate The coupon may be paid every six months or annually. Referring back to the example above, if the bond mentioned on the bond pays a semi-annual coupon, then £35 will be paid every six months. UK government bonds (known as is always the gross amount, regardless of gilts) and US government Treasury bonds both pay a semi-annual coupon. Occasionally, a bond may whether tax is withheld or not. pay a quarterly coupon, eg, some floating-rate notes (FRNs). When the bond reaches its maturity date, it means the loan period ends, and the issuer pays backWith some bonds, the coupon is paid without tax being withheld. This is termed a gross payment. Other the principal amount to the bondholder. This bonds pay the coupon with tax withheld. This is termed a net payment. Whether payments are made typically not subject to gross or net depends on the tax legislation of the country concerned, but the coupon rate in the title of repayment at maturity is withholding tax, although it might be subject to the bond will always be the gross amount. capital gains tax or income tax. For example, let's say When the bond reaches its redemption date, it is said to mature and the bond is then redeemed. you have a bond with a face value of $1,000 In the example, the bond was issued with a five-year maturity. After one year has elapsed, it will have and an annual coupon rate of 5%. If it's a a four-year maturity. The repayment of the principal of the loan at maturity is not usually subject to gross payment bond, you'll receive the full 5% withholding tax (WHT), although it may be subject to capital gains tax or income tax. interest each year without any tax withheld. But if it's a net payment bond, the issuer might deduct Bonds are typically classified as short, medium and long maturity. The UK Debt Management Office (DMO), taxes before paying you for example, which issues UK gilt securities (ie, UK government bonds), categorises gilt maturities as follows: the interest. At maturity, you'll receive the full $1,000 principal amount back, regardless of whether Short: 0–7 years. tax was withheld on the i nterest payments. Medium: 8–15 years. Long: 15+ years. Gilts with a maturity of less than three years are sometimes labelled ultra-short. Gilts with a 50-year maturity, which have been issued by the DMO since 2005, are sometimes labelled ultra-long. The coupon reflects the interest rate payable on the nominal amount. However, an investor will have paid a different amount to purchase the bond, so a method of calculating the true return is needed. The return, as a percentage of the cost price, which a bond offers is often referred to as the bond’s yield. The interest paid on a bond as a percentage of its market price is referred to as the flat or running yield. Intt paid / Market Price = Flat or Running Yield 13 Return as a percentage of cost price = Bond's yield This is calculated by taking the annual coupon and dividing it by the bond’s price and then multiplying by 100 to obtain a percentage. Risk of Default The price of a bond will reflect interest rates. It will also reflect the risk that the issuer of the bond will fail to meet the two promises to pay interest and to repay the capital on maturity. This is known as default risk. It is difficult to quantify default risk with the same precision as yields, but the investor must draw on as broad a range of risk measures as possible in order to evaluate the expected return on a bond investment against the associated risks borne in holding this instrument. For large issues of bonds, such as those taking place in the eurobond market (see section 3.1.4), there are specialist rating agencies (for example, Standard & Poor’s, Moody’s, Fitch), which give each bond issue a credit rating that reflects the agency’s assessment of the likelihood of default. The most secure bonds are given a AAA rating, referred to as triple A, according to Standard & Poor’s. Bonds that are less secure will have a lower price, and thus a higher yield, than a triple A-rated bond. Bonds with a Standard & Poor’s rating of BB or below are considered to be speculative/junk/high-yield/sub-investment grade rather than investment grade. 3.1 Types of Fixed Income Instrument Bonds are typically labelled according to who issues the bond, which market they are issued in, and any defining characteristics that differentiate the instrument from a standard fixed-interest bond. 3.1.1 Government Bonds The bonds issued by politically stable and traditionally economically strong governments, such as the US, Germany and the UK, are typically among the most secure marketable invest­ments in the world. The risk of default on sovereign debt (as government debt issues are generically known) in more volatile developing economies, and some struggling European economies, is significantly higher. Governments may issue debt instruments denominated in their domestic currency or in a foreign currency. Whereas governments rarely default on domestic currency government debt, default on foreign currency government debt is more common. Sovereign risk is the name given to the risk that a government will fail to honour its debt obligations to creditors. Widely traded government bonds include: US – Treasury bonds or Treasury notes UK – Gilt-edged securities (or gilts) Japan – Japanese government bonds (JGBs) Germany – Bunds, Bobl and Schatz France – OATs and BTANs. 14  Securities 1 3.1.2 Domestic Bonds This is a bond issued by a borrower resident in the country of issue, denominated in the local currency and regulated by the regulatory authority of the jurisdiction concerned. For example, a bond issued by a US company, denominated in US dollars and regulated by the US Securities and Exchange Commission (SEC), is a US domestic bond. 3.1.3 Foreign Bonds A foreign bond is one issued by a foreign issuer in the local currency in the local market. For example, a US dollar bond issued in the US by a non-US company is a foreign bond. Foreign bonds are often given colloquial names: Name Currency Issuer Market Yankee US Dollar Non-US US Samurai Yen Non-Japanese Japan Bulldog Sterling Non-UK UK Matador Euro Non-Spanish Spain 3.1.4 Eurobonds A eurobond is a bond issued by a company and sold to investors outside the country where the currency is employed. For example, a US-denominated bond sold outside the US (designed to borrow US dollars circulating outside of the US) would typically be referred to as a eurodollar bond. This may, for example, 15 represent a dollar-denominated debenture issued by a Dutch company through an underwriting group consisting of a syndicate of investment banks (eg, Dutch, UK and US investment banks). Coupon payments on eurobonds are subject to the tax legislation of the country where the payment is effected. Interest on bonds held in a recognised clearing system is typically paid gross. For more about eurobonds, see section 8.4. 3.1.5 Convertible Bonds A convertible bond is a bond that gives the holder the right, but not the obligation, to convert the bond into a specified number of underlying shares (normally ordinary shares) of the issuing company on terms that are set out at the time of issue of the bond. Convertible bonds commonly pay lower interest than straight bonds, but provide greater opportunity for capital gain if the price of the underlying shares of the company appreciates during the loan period. In the same way as regular bonds, holders of unconverted bonds at maturity retain the right to redeem the bonds at nominal value. The conversion rate is the number of shares that are received for each bond unit. For example, an investor exercising a convertible bond with a conversion rate of two will receive two shares for each bond unit exercised. An exchangeable bond is a hybrid security consisting of a bond and a conversion option to exchange the bond for the shares of a company other than the issuer (usually a subsidiary or related company). Contingent convertible bonds (also known as CoCos) are very similar to traditional convertible bonds. The key difference, however, is that a price is set, which the underlying equity share price must reach before conversion can take place (ie, conversion is contingent on the ordinary shares attaining a certain market price over a specified period of time). 3.1.6 Discount Securities Zero coupon bonds A discount bond is a bond issued at a price that represents a discount to the redemption price at maturity. Zero coupon bonds represent one form of discount security. This type of bond does not pay interest, but the price paid by the investor to acquire this bond at the time of issue is at a discount to the capital redemption price at maturity. As such, the investor receives no coupon income, but receives a capital gain at redemption. This type of issue may be attractive for companies wishing to borrow money to finance a project that has a long development time. As such, they do not wish to be paying out coupon payments throughout the loan period when income generated by the project may be low, but would prefer to repay a capital lump sum at redemption, when it is hoped that the project will be well established and generating sizeable returns. Discount securities may also be attractive to investors because of, for example, tax considerations and the timing of cash flows. 3.1.7 Floating-Rate Notes (FRNs) A floating-rate note (FRN) is like a bond, except that its coupon is linked to a floating interest rate. For example, an FRN might pay a semi-annual or quarterly coupon linked to a reference or benchmark rate, such as the Sterling Overnight Index Average (SONIA). SONIA is based on actual transactions and 16  Securities reflects the average of the interest rates that banks pay to borrow sterling overnight from other financial 1 institutions and other institutional investors. A company might issue an FRN if it believes that interest rates will fall in the future and it does not want to lock into a high fixed coupon rate; or it may wish to issue an FRN if it has floating-rate receipts in order to match the interest rate basis of its receipts and payments, thereby hedging against unexpected and/ or adverse changes in interest rates. 3.1.8 Asset-Backed Securities (ABSs) Asset-backed securities (ABSs) are issued against a pool of loans – which may be credit card debt, student loans, automobile loans, property loans or other types of loan contract. They can sometimes be issued against other types of expected future cash flows, eg, royalties. In creating an ABS, the originator of the loan will typically sell a pool of its outstanding loans to a third party. The buyer may elect to securitise this package of loans by issuing securities – underpinned by cash flows from the pool of underlying loans – which can be bought and sold by investors just like any other tradeable securities. On purchase, the ABS holder will acquire the right to a share of the cash flows resulting from loan repayments, but will also take on the risk of potential default by borrowers on their repayments. 3.1.9 Mortgage-Backed Securities (MBSs) A mortgage-backed security (MBS) is a type of ABS (see section 3.1.8) that uses a single mortgage, or a pool of mortgage loans, as collateral. Investors receive payments derived from the interest and principal of the underlying mortgage loans. 3.1.10 Index-Linked Bonds Index-linked bonds (variable or floating-rate) are fixed-income securities where the coupon payment (ie, the income) and the principal (the price at which the bond will be redeemed) are adjusted to take into account movement in retail prices. In the UK, this adjustment may be made according to movement in the Retail Prices Index (RPI), for example. Example Assume that an index-linked bond is issued at its par value of £100, with a 2% coupon. Consider that, over a five-year term, retail prices rise by 25%. As a result, the bond will be redeemed at £125. The interest paid on these bonds will also increase by 25% over this five-year period, such that the bond pays a real interest rate of 2%. Thus, the interest paid across the five-year term will be 2% on the revised redemption value of £125 (which is equivalent to 2.5% on the original £100 nominal value). 17 3.1.11 Green Bonds Green bonds are issued by private firms and public entities to raise funds to finance projects that have a positive environmental impact, such as renewable energy and green construction of buildings. For investors, the attraction is that they allow investment that contributes to social and environmental impacts. 3.1.12 Sustainability-Linked Bonds Sustainability-linked bonds (SLBs) are issued with specific performance targets relating to sustainability. Eg, ‘the amount of recycled materials used in a firm’s manufacturing process must exceed ‘xx’ by the year 2035’. If the company fails to meet a target they receive a penalty, in the form of being forced to pay higher interest to its bondholders. This built in penalty is known as a ‘Step Up Clause’. 3.2 Clean and Dirty Prices Interest entitlements on UK gilt-edged securities, and on many other fixed-income securities, are paid twice per year. During the period leading up to the next value date for a coupon payment, interest will accrue on a daily basis. If the security is sold during this period, the seller typically has an entitlement to any interest that has accumulated since the last coupon date. Market convention dictates that the buyer will normally compensate the seller for this accrued interest at the time of settlement. Hence, the accrued interest due to the seller will be added to the buyer’s purchase cost and forwarded to the seller. In many jurisdictions, the transaction price actually quoted for the debt security must exclude the accrued income. This is known as the clean price. Under UK tax law, for example, the clean price and accrued interest must be quoted separately for accounting and tax declaration purposes. The capital value (as valued on the transaction date by the clean price) will be subject to capital gains tax rules, whereas any accrued income will be taxed under income tax rules. Please be aware that, if the investment is a gilt-edged security or deemed qualifying (referred to as a Qualifying Corporate Bond), then it will be exempt from capital gains tax. When a price is quoted for a debt security that includes the accrued interest, this is known as the dirty price. 3.3 Calculating Accrued Interest on Bonds When a bond is sold, the accrued interest will need to be calculated and added to the clean price that the buyer pays the seller. If the trade settlement date is after the record date (see chapter 4, section 5.5), the coupon will be paid to the seller and the accrued interest then subtracted from the clean price. The first of these is known as a cum-interest transaction and the second is known as an ex-interest transaction. 18  Securities Example: Cum-Interest Transaction 1 A cum-interest transaction is agreed. £200,000 5% Treasury 2030 are traded on 3 March for settle­ ment on 4 March. Graphically: 15 January Trade date 3 March (due seller) 181 days Pay date Settlement Pay date 15 January 4 March 15 July The interest due to the seller can be calculated by the following formula: days of accrual Accrued interest = nominal value × coupon for the period × days in coupon period The days of accrual will be between the day of the most recent coupon payment (15 January) and the day before the transaction settlement date (3 March), both days included, which is 48 days, and there are 181 days in the coupon period. More generally, it will be annual coupon/number of coupons in the year. This would give: nominal value annual coupon × days of accrual = Accrued interest × number of coupons days in coupon period The accrued interest is added to the clean price. 19  Example: Ex-Interest Transaction An ex-interest transaction is agreed. £200,000 5% Treasury 2028 are dealt on 10 July for settlement 11 July. Graphically: The accrued interest on an ex-interest transaction is called rebate interest. The rebate interest is deducted from the clean price. The days of accrual are the days from the day of the transaction settlement date (11 July) through to the day before the next coupon payment (14 July), both days inclusive, which is 4 days. Trade date Settlement date 10 July 11 July 181 days 11 July 14 July (due buyer) Pay date Record date Pay date 15 January 8 July 15 July 3.3.1 Accrual Conventions There are four common methods of calculating the interest payable on interest-bearing bonds. These are called interest rate conventions. Some bonds will use a 30/360 convention, while others will use the actual number of days in the month or year. Each convention differs slightly in the assumptions about the calculation of the period over which interest is payable. The conventions change depending on the market, for instance: UK corporate bonds pay interest based on actual/365-day convention US corporate bonds pay interest based on actual/360-day convention eurobonds generally pay interest based on the 30/360 day convention, and most government bonds pay interest based on the actual/actual convention. 20  Securities 30/360 1 This case assumes and bases the calculation on there being 30 days in each and every month and 360 days in a year. For example, if XYZ bonds are acquired on settlement date 1 April and sold for settlement day 2 July, the buyer will receive all the interest accrued during the period 1 April to 1 July (ie, the day before settlement date). The settlement process is calculated as follows: 1 April–30 April = 30 1 May–31 May = 30 1 June–30 June = 30 1 July = 1 91 days Number of days in year is: 12 × 30 = 360. interest number of days in period (assuming 30 days in month) Accrued interest = nominal × × 100 360 Actual/Actual The calculation for actual/actual is the same as above, except that the number of days is: 1 April–30 April = 30 1 May–31 May = 31 1 June–30 June = 30 1 July = 1 92 days This convention assumes the number of days in the year is equal to the calendar days in the interest period, multiplied by the number of interest periods in the year. Accrued interest = calendar days in period nominal value × annual coupon (%) × (calendar days in period) × (number of interest periods in year) Actual/360-Day Convention This case assumes and bases the calculation on a 360-day year. actual days in period Accrued interest = nominal value × annual coupon (%) × 360 21 Actual/365-Day Convention This case assumes and bases the calculation on a 365-day year. actual days in period Accrued interest = nominal value × annual coupon (%) × 365 Example Question Investor X holds $1 million corporate bonds of ABC ltd with a coupon of 6%. Interest is paid quarterly and the interest periods are: 1 January–31 March, 1 April–30 June, 1 July–30 September, 1 October–31 December. Calculate the amount received by the investor per period and in total for each of the four interest rate conventions. Answer The interest rate periods are 90 days, 91 days, 92 days and 92 days respectively. Actual/360-Day Convention: Q1: Interest paid = $1m x 0.06 x 90/360 = $15,000 Q2: Interest paid = $1m x 0.06 x 91/360 = $15,166.67 Q3: Interest paid = $1m x 0.06 x 92/360 = $15,333.33 Q4: Interest paid = $1m x 0.06 x 92/360 = $15,333.33 Total interest received = $60,833.33 Actual/365-Day Convention: Q1: Interest paid = $1m x 0.06 x 90/365 = $14,794.52 Q2: Interest paid = $1m x 0.06 x 91/365 = $14,958.90 Q3: Interest paid = $1m x 0.06 x 92/365 = $15,123.29 Q4: Interest paid = $1m x 0.06 x 92/365 = $15,123.29 Total interest received = $60,000.00 22  Securities 30/360-Day Convention: 1 Q1: Interest paid = $1m x 0.06 x (3x30)/360 = $15,000 Q2: Interest paid = $1m x 0.06 x (3x30)/360 = $15,000 Q3: Interest paid = $1m x 0.06 x (3x30)/360 = $15,000 Q4: Interest paid = $1m x 0.06 x (3x30)/360 = $15,000 Total interest received = $60,000.00 Actual/Actual Convention: Q1: Interest paid = $1m x 0.06 x 90/(90x4) = $15,000 Q2: Interest paid = $1m x 0.06 x 91/(91x4) = $15,000 Q3: Interest paid = $1m x 0.06 x 92/(92x4) = $15,000 Q4: Interest paid = $1m x 0.06 x 92/(92x4) = $15,000 Total interest received = $60,000.00 Example On 22 July, purchaser X buys £100,000 bonds at 98.125% from seller Y. These bonds have a coupon of 6%, which is paid semi-annually on 1 April and 1 October. Interest is calculated on actual/365-day convention basis. What is the total amount payable to seller Y, assuming that the trade settles on a T+3 basis and that accrued interest is calculated up to the day prior to the settlement date? Price = 98.125%, therefore the principal amount is £98,125.00 On settlement date minus one (24 July), the bonds have accrued 115 days interest since the last payment date of 1 April. Accrued interest = £100,000 x 6% x 115/365 = £1,890.41 Taxable under income tax law Total amount payable = £98,125.00 + £1,890.41 = £100,015.41 Exercise 1 £100,000 7% bonds are purchased for settlement on 1 April and sold for settlement date 28 June. If the investor receives all the interest accrued during this period, calculate accrued interest using: a. 30/360 convention, b. actual/365 convention. The answers can be found at the end of the chapter. 23  Exercise 2 £200,000 8% bonds are traded cum-interest. Interest is calculated on actual/365-day convention basis. How much interest will the buyer pay to the seller if there are 100 days of accrued interest? The answers can be found at the end of the chapter. Exercise 3 £100,000 7% bonds are traded ex-interest. Interest is calculated on actual/360-day convention basis. How much interest will the seller pay to the buyer if there are 175 days of accrued interest and the coupon period is 180 days? The answers can be found at the end of the chapter. 4. Warrants Just like call option Learning Objective 1.1.4 Understand the characteristics of warrants and covered warrants: what are warrants and covered warrants; how they are valued; effect on price of maturity and the underlying security; purpose; detachability; exercise and expiry; benefit to the issuing company and purpose; issue by a third party; right to subscribe for capital A warrant gives the holder the right, but not the obligation, to subscribe to an ordinary share or a bond at a specified price on or before a specified date. In other words, they give the holder the right to purchase the underlying share or bond. Warrants are bought and sold on exchanges in the same way as equities and bonds. However, they pay no income to the warrant holder. Thus, the warrant holder will not be eligible for dividends paid on the underlying shares (unless the warrant is exercised). The amount that the investor pays for the warrant is called the premium. This is commonly a fraction of the price of the underlying asset. 24  Securities 1 Example An investor buys a warrant at a strike price of £1 and pays a premium of 20p per warrant. If the warrant expires without the underlying share price going above £1, the investor will make a loss of 20p (the premium). A warrant is said to be out-of-the-money if the underlying share price is lower than the strike price. If the underlying share price rises above £1, the investor has the right to buy the shares at £1, sell them on the market at the higher price and keep the difference. A warrant is said to be in-the- money if the underlying share price is higher than the strike price. Plotting profit/loss against share price gives: Profit/loss on expiry or when trading out Break-even point (£1.20) Strike price (£1) £1.60 Warrant Premium Price of underlying (20p) share Price 1.20 If the price of the share goes up as far as £1.20, the investor will break even. The investor can buy Investor buy for 1 Sell for 1.20 the shares at £1 as per the warrant, and then sell them to the market at £1.20. He/she will make He makes 20p. 20p on this transaction, which will offset the 20p paid for the warrant. Any further increase in the Premium = 20p Premium will be price of the share is profit. offset with the increased. If the price rises as far as £1.60: Profit per warrant = Price of underlying share – strike price – warrant premium = £1.60 – £1 – 20p = 40p The investor, therefore, has a limited loss – the 20p paid – but, potentially, an unlimited profit. Hence, we note that the warrant provides a degree of gearing to the investor. A 20p initial investment in the warrant has translated into a 40p profit. This profit will increase further if the share price continues to rise. 25 The price that the warrant trades at in the market will be related to the current share price, but also to the expectation of what the share price will do before the warrant expires. A range of variables can shape how the price of a warrant will move, including the price of the underlying instrument, the exercise price of the warrant, time left to expiry date, the volatility of the underlying instrument, interest rates and dividend expectations for the underlying share. A company may have a variety of reasons for issuing warrants. For example, it may issue warrants when raising capital through issuing stock. It may also issue warrants alongside the share issue in order to improve the attractiveness of the stock issue and, ultimately, to raise more capital for the company. For example, a company may issue 500,000 shares at £20 per share, thereby raising £10 million in capital. However, it anticipates that it may raise further capital from investors if it also issues 100,000 warrants, each sold at a premium of £2 and with an exercise price of £16. An investor holding the warrant will have the right to exercise the warrant with a specified period in which to purchase the ordinary share (ie, providing the warrant is in-the-money). By doing so, the company may raise further capital from investors that had been unwilling to subscribe to the original share issue at £20 per share. Companies may issue warrants, for example, as a ‘sweetener’ for a bond or preferred stock offering. By adding the warrants, the company aims to improve the terms on which it can raise capital through issuing bonds or preference shares. Moreover, warrants represent a potential source of equity capital in the future and can thus offer a capital-raising option to companies that cannot, or prefer not to, issue more debt or preferred stock. For example, a company may sell a corporate bond with a face value of US$2,000 with warrants attached, entitling the holder to buy 200 ordinary shares in the company at US$10 per share during the next two years. If the share price rose to US$15 per share during this period, the holder could exercise the warrants, purchasing 200 ordinary shares at US$10 each. If the investor sold shares immediately in the open market at US$15 per share, it would realise a gain of: 200 × (15 − 10) = US$1,000 Thus, the minimum value of each warrant at this point in time would be US$1,000 / 200 = US$5 per warrant. In practice, some investors may be willing to pay more than US$5 per warrant, believing that the share price would rise higher than US$15 during this two-year period. If an investor anticipated that the share price might rise to US$20, for example, it may be willing to pay: 200 × ( 20 − 10) /200 = US$10 ie, it may be willing to pay up to US$10 for the warrant. 26  Securities More broadly, companies may issue warrants for a number of other reasons, which include the following: 1 It may issue warrants to staff as part of their staff benefits or remuneration package; or through an agreement with a trade union in recognition, for example, of a change of working practice or staff rights. During the global financial crisis, several US companies were required to issue warrants to the US government in exchange for receiving financial assistance from the government. In some circumstances, a law court may instruct a company to issue warrants as part of a settlement when a class of litigants has brought legal action against the company. A covered warrant is a type of warrant A covered warrant has similar behavioural characteristics to those outlined for a warrant above. where the issuer However, a warrant is issued by a company over its own underlying shares. When the warrant expires, is a financial institution rather the company will deliver the requisite quantity of shares to the warrant holder. In contrast, a covered than an individual warrant is a synthetic product structured by an investment bank or another financial institution over company and offers the right, a range of possible underlying assets, which may be a share in a company, a share price index, a but not obligation, commodity, a currency or a basket of currencies. to buy or sell an asset at a specified price All UK covered warrants are cash-settled rather than stock-settled. This means that the issuer pays a cash on or before a sum for the intrinsic value of the warrants at the expiry date, or on exercise. In other words, although the specified date. terms of warrants are usually expressed as a right to purchase the underlying share(s), a covered warrant is more accurately a right to receive a cash payment equivalent to the difference between the exercise price and the value of the underlying asset at expiry. Example An investor holds 5,000 covered warrants with the right to buy one share at 100p. At final maturity date, shares close at 140p. Cash settlement = (share price – exercise price) x number of covered warrants. Cash settlement = (140 – 100) x 5,000 = £2,000. The terms ‘European-style’ and ‘American-style’ are sometimes used to describe the different ways that warrants may be exercised. The distinction is: American-style means the warrants can be exercised at any time on or before their expiry date. European-style means the warrants may only be exercised on the expiry date of the warrant. 27 Further characteristics of warrants and covered warrants are summarised in the following table: Traditional warrants Covered warrants Issued by an investment bank or institution over other assets, Issued by a company over its which may be a share in a company, a share price index, a own company shares commodity, a currency or a basket of currencies New shares issued upon No new shares issued on exercise; an equivalent value payment exercise is made to the warrant holder in cash Maturities typically several Shorter maturities – typically one or two years years warrants can sweeten the deal when a company issues bonds. Let's say Company A wants to raise money by issuing Source: London Stock Exchangebonds, but investors are worried about inflation. To make the bonds more appealing, Company A offers equity warrants along with the bonds. For every £3.00 of bonds purchased, investors also get one warrant. These warrants give investors the right to buy Company A's stock at a set price in the future. So, by offering these warrants, Company A makes the bond offer more attractive to investors, encouraging them to buy the bonds despite concerns about inflation. Warrants are sometimes used to make an issue of loan stock more attractive to potential investors. During periods of high inflation, investors may be cautious about buying or subscribing for loan stock. In such circumstances, the issuer may also offer equity warrants to subscribers of the bond issue. For example, they may be offered one warrant for each £3.00 of loan stock, thus increasing the loan stock’s appeal. If the share price of the company rises above the warrant strike price, this will enhance the returns accruing to the investor. When warrants are issued in this manner, they are commonly traded separately from the loan and are said to be detachable. In the UK, an attraction of cash-settled covered warrants is that they are exempt from the 0.5% transaction tax duty levied on share transfers. Exercise 4 An investor buys 50 warrants for a premium of £0.20 each and a strike price of £1.25. To what level will the share price need to rise if the investor is to make a profit of £30.00? The answers can be found at the end of the chapter. 28  Securities let's say you want to invest in a company listed on the New York Stock Exchange (NYSE) but you live in the UK. Instead of buying shares directly on the NYSE, you can purchase depository receipts issued by a UK bank that represent ownership of the NYSE-listed company's shares. These depository receipts are traded on the UK stock exchange, making it easier for UK investors to access international markets. 5. Depositary Receipts (DRs) 1 https://youtu.be/6JLQBWKKTwA?si=Bmh-TXP5TFSBr0KH Learning Objective 1.1.3 Understand the characteristics of depositary receipts (DRs): American depositary receipts (ADRs); global depositary receipts (GDRs); depositary interest; transferability/registration/transfer to underlying; how created/pre-release facility; entitlement of corporate actions; taxation and conversion fees Depositary receipts (DRs) are financial instruments that mirror the shares of a foreign company. For example, an investor may buy a DR in an Indian company that is traded on the German market. The DR represents the underlying shares in the Indian company, but it is denominated in euros and can be bought and sold on the Luxembourg market, trading either OTC or, if it has satisfied exchange listing requirements, on a stock exchange or MTF. Any dividends or other entitlements due on the underlying share will be paid in euros on the DR. There are several steps to creating a DR. Consider, for example, that a foreign company registered and listed in Country A will create a DR in Country B. Typically, a broker from Country B will buy a quantity of shares in the company in its home market (A). These shares will be deposited with a depository bank in Market A. The depository bank will then create DRs in Market B. The depository bank will set the ratio of DRs per underlying share. The DR can be freely traded in the secondary market in Country B and will be subject to Country B’s market regulations and tax requirements. The price of the DR – denominated in currency B – should mirror the price of the underlying shares (denominated in Country A’s currency) held by the depository bank. DR holders usually have a right to convert their DRs into underlying shares. In some instances, a DR programme may be terminated, potentially at the request of the issuer company or the depository bank. DR holders will typically be notified in advance and will have the right to exchange their DRs for underlying shares. 5.1 American Depositary Receipts (ADRs) A common type of DRs are American depositary receipts (ADRs). ADRs are issued in the US in US dollars and provide a mechanism through which US investors can reduce the costs and risks associated with investing in non-US companies (see example below). ADRs must comply with various SEC rules, including the full registration and reporting requirements of the SEC’s Exchange Act. 29  Example A US investment bank, NYC, purchases ten shares in the UK company British Land on the London Stock Exchange (LSE). NYC then registers the shares with the SEC, the US regulator, in order to issue and market ADRs in British Land. When approval has been granted, NYC applies to the New York Stock Exchange (NYSE) to list and trade British Land ADRs on the exchange. In essence, the British Land ADR is a repackaged British Land share, backed by British Land ordinary shares that are owned by NYC. The ADRs are valued in US dollars and trade like any other ordinary share on the NYSE. NYC will set up an arrangement with a custodian bank for the latter to act as the depository bank for the ADRs (the Bank of New York Mellon, Citi and J.P. Morgan Securities Services hold the largest market share for this service in the US). The underlying shares will be deposited with the depository bank in the UK market (or with the depository bank’s local agent, or subcustodian, in the UK market – see chapter 2, section 2.1). Dividends paid by British Land are received by the depository bank and distributed to British Land ADR-holders in US dollars in direct proportion to their ADR holding. If British Land withholds tax on dividends before this distribution, then the depository bank will withhold a proportional amount before distributing the dividend to ADR holders. Subsequently, holders of the British Land ADR may trade the ADR in the secondary market, either via an exchange transaction or OTC, just like any other US-listed security. The ADR holder is entitled to instruct NYC to cancel the British Land ADR at any point and to convert this back into the underlying British Land ordinary share. NYC, as investment bank, will typically receive a commission or management fee for overseeing the ADR issuance and marketing process, and the custodian depository will also receive fees. Indeed, typically, holders of an ADR will be required to pay a conversion fee to the manager of the ADR programme when wishing to convert the ADR to the underlying share. Similarly, holders of the underlying ordinary shares will be subject to a conversion fee when wishing to convert these shares into an ADR. To summarise, DRs overcome a number of problems facing investors wishing to hold a foreign company’s shares. 30  Securities The following table uses ADRs as an example: 1 Characteristics of Holding American Depositary Receipts Compared with Holding a Company’s Ordinary Shares in a Foreign Market Issue Holding Foreign Shares Holding an ADR Foreign Some countries do not allow As a US security, the ADR is not subject to ownership foreign ownership of local local ownership restrictions. if an investor in the restrictions companies. USA wants to buy shares of a company Ordinary shares traded in the local listed on the Settlement market may be subject to extended ADRs settle according to a T+2 settlement London Stock Exchange, they procedures settlement cycles and inefficient cycle, just like any other US-listed share. would need to settlement procedures. convert their US dollars into British Foreign Shares have to be paid for in the pounds to pay for those shares. This exchange foreign currency, requiring an FX ADRs settle in US dollars. conversion from (FX) transaction. one currency to another is known as an FX transaction. Dividends are paid in foreign Dividend The investor would currency, requiring periodic FX ADRs pay dividends in US dollars. typically do this payments through their bank transactions. or a currency exchange service, ADRs typically provide the holder with the and there may be right to vote, but not to participate in rights associated fees or exchange rates to issues. Shareholders receive the proceeds consider. of the sale of the rights (if any). However, Rights Shareholders have the right to vote this may vary according to the terms of the issues/ and to participate in rights issues depository agreement. Likewise, details of corporate and other corporate actions. other corporate actions will be notified to actions the ADR holder by the custodian holding the ADRs, but participation, requirements and procedures may vary according to the depositary agreement. ADRs trade on US stock exchanges and OTC. There may be a lack of liquidity in Liquidity Consequently, they can be more liquid than the foreign market. underlying shares. For UK and Irish securities, where UK share purchases are generally ‘chargeable securities’ are transferred to a Transfer subject to a 0.5% charge (1% in DR issuer or its nominee, in return for the taxes Ireland). issue of a DR by the depositary, tax at a rate of 1.5% will usually apply. The legal framework in the foreign country may offer limited Legal ADRs comply with US securities legislation protection to the investor. Local framework and accounting principles. legal procedures may be difficult to interpret in the case of a dispute. 31  A pre-release facility is a process where a depository (a financial institution that issues depositary receipts or DRs) issues DRs to investors before it has received the actual underlying shares from the foreign company. This facility allows the DRs to be traded and provides liquidity in the market even before the shares are deposited. 5.2 Pre-Release Facility