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Banking Awareness

Financial Instruments – Part Two

Written by A Moorthy

Before you proceed i would like to suggest you to go through our previous post:  Financial Instrument – 1

The capital market generally consists of the following long term period i.e., more than one year period, financial instruments; in the equity segment Equity Shares, Preference shares, Convertible Preference Shares, Non-Convertible Preference Shares etc and in the debt segment debentures, zero coupon bonds, deep discounts bonds etc.

Equity Segment

Equity Shares: In accounting and finance Equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists. In an accounting context, shareholders’ equity (or stockholder’ equity, shareholders funds, shareholders capital or similar terms) rep resents the remaining interest in assets of a company, spread among individual shareholders of common or preferred stock.

Shareholder’s equity: When the owners are shareholders, the interest can be called shareholders equity; the accounting remains the same, and it is ownership equity spread out among shareholders. If all shareholders are in one and the same class, they share equally in ownership equity from all perspectives. However, shareholders may
allow different priority ranking among themselves by the use of share classes and options. This complicates both analysis for stock valuation and accounting.

Market value of Shares: In the stock market, market price per share does not correspond to the equity per share calculated in the accounting statements. Stock valuations, which are often much higher, are based on other considerations related to the business’ operating cash flow, profits and future prospects; some factors are derived from the accounting statements.

Equity in Real Estate: The notion of equity with respect to real estate makes the equity of redemption. This equity is a property right valued at the difference between the market price of the property and the amount of any mortgage or other encumbrance.

Preference Shares: Preference shares, or simply preferred, are a special equity security that has properties of both equity and a debt instrument and is generally considered a hybrid instrument. Preference Shareholders are senior (i.e. higher ranking) to common stock, but are subordinate to bonds in terms of claim or rights to their share of the assets of the company. Preference shares usually carry no voting rights, but may carry a dividend and may have priority’ over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are stated in a “Certificate of Destination”. Similar to bond, preferred stocks are rated by the major credit rating companies. The rating for Preferred is generally lower since preferred dividends do not carry the same guarantees as interest payments from bonds and they are junior to all creditors.

Convertible Preference shares: These shares are corporate fixed income securities that the investor can choose to turn into a certain number of shares of the company’s common stock after a predetermined time span or on a specific date. The fixed income component offers a steady income stream and some protection of the investor’s capital. But the option to convert these securities into stock gives the investor the opportunity to gain from a rise in share price. Convertibles are particularly attractive to those investors who want to participate in the rise of hot growth companies while being insulated from a drop in price should the stocks not live up to expectations.

Debt segment

Debentures: A debenture is a document that either creates a debt or acknowledges it, and it is debt without collateral. In corporate finance, the term is used for a medium to long-term debt instrument used by large companies to borrow money. In some countries the term is used interchangeably with bound, loan stock or note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company’s capital structure, it does not become share capital. Senior debenture gets paid before subordinate debentures, and there are varying rates and payoff for these categories.

Debentures are generally freely transferable by the debenture holder. Debenture holders have no rights to vote in the company’s general meetings of shareholders, but they may have separate meetings or votes e.g. on changes to the right attached to the debentures. The interest paid to them is a charge against profit in the company’s financial statements.

There are two types of debentures:
1. Convertible debentures, which are convertible bonds or bonds that can be converted into equity shares of the issuing company after a predetermined period of time. “Convertibility” is a feature that corporations may add to the bonds they issue to make them more attractive to buyers. In other words, it is a special feature that a corporate bond may carry. As a result of the advantage buyer a gets from the ability to convert, convertible bonds typically have lower interest rates than non-convertible corporate bonds.
2. Non-Convertible debentures, which are simply regular debentures, cannot be converted into equity shares of the liable company. They are debentures without the convertibility feature attached to them. As a result, they usually carry higher interest rates than their convertible counterparts.

Zero Coupon Bonds : A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called “coupons”, hence the term zero-coupon bound. When the bond reaches maturity, its investor receives its par (or face) value. Examples of zero-coupon bonds include U.S. Treasury bills, U.S. Savings bonds, long-term zero coupon bonds and any type of coupon bond that has been stripped of its coupons.

Deep Discount bonds: A Bond that is selling at a discount from par value and has a coupon rate significantly less than the prevailing rates of fixed-income securities with a similar risk profile.

Hybrid instruments: Hybrid instruments have both the features of equity and debenture. This kind of instruments is called as hybrid instruments. Examples are convertible debentures, warrants etc.

Warrants: In finance, a warrant is a security that entities the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiry date.

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A Moorthy

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