Definition of Innovations in Financial Instruments

Innovations in Financial Intruments

The uncertainty in the movement of foreign exchange rates has, as explained earlier led to the development of various markets such as the forward market, futures markets, options market, Europe market and the interbank market. New financial instruments have also been introduced in response to the uncertain movement in exchange rates. The objective was to maintain the attractiveness of long-term instruments, as these were the one, which faces increased uncertainty and volatility in exchange rates.

Floating Rate Notes (FRS)

Floating rate notes were first issued in 1978 in the Euromarkets. But just what are floating rate notes?

Floating rate notes are debt instruments on which interest rates are set usually semi- annually, at a margin above a specified interbank rate. The usual benchmark is the London interbank offered rate (LIBOR). Because the interest rate payable on the instrument rises with the general rise in interest rates as indicated by LIBOR or some other interbank market rate, the investor risk to that extend minimized.

So we see the risk due to the adverse movement in exchange rates is reduced owing to the changing interest rate payable on the instrument.

Multiple Currency Bonds

Multiple currency bonds are denominated in cocktails of currencies. They are popular because they reduce currency risk below the level that would prevail if the bond were denominated in a single currency. Depreciation of one currency can be offset against appreciation in other over the maturity of the bond.

You wonder in what currency the investor is paid at the expiry of the maturity period of the instrument.

Well the investor is paid according to the contractual agreement, which may stipulate payment in one or several currencies.

Zero Coupon Bonds

Zero coupon bonds are just what they state. They carry no coupon payments or interest payments over the life of the instrument.

Then why does anyone want to purchase these instruments?

The answer is the deep discount at which instruments are sold in the market place. The payment at maturity will be the face value of the instruments; the difference between the purchase price and the repayment value amounting to implicit interest. Therefore, this bond is useful for an investor who wishes to hold the instrument until maturity and avoid frequent reinvestment of interest payment. Some tax advantages may also be available.

Bonds with Warrants

These are fixed rate bonds with a detachable warrant allowing the investors to purchase further fixed rate bonds at a specified rate at or before a specified future date. The investor holding this warrant has the option of holding it until maturity or of selling it in what is called a ‘derivative market’.

A derivative market is one in which risk is traded separately from the financial instrument. Example are warrants of course; but besides that we have options- a term you have come across before as also swaps about which you will learn more in the subsequent paragraphs.

The value of the warrant you would agree depends on interest rate movements. If interest rates rise sharply subsequent to the issue of bonds, there obviously will not be buyers to purchase this bond. The value of the warrant then shall become zero.

Convertible Bonds

A convertible bond comprises an ordinary bond plus an option to convert at some data into common stock or some other tradable instrument at a pre-specified price. The option by the investor shall be exercised only if the market price at the date of conversion is higher than the pre-specified price.

The advantage derived from conversion is likely to eliminate the cost of uncertainty arising from variable exchange rates.

Swaps

Swaps have gained immense importance in the derivative market. This is because swaps allow arbitrage between market, between instruments, and between borrowers without having to wait for the market themselves to cast down the barriers. There are as many different swap arrangements as there are varieties of debt financing and with the volatile exchange rates of the 1980s, demand for them is high

Here we shall describe the basics of two kinds of swaps: interest rate swap and currency swap.

In an interest rate swap, two unrelated borrowers borrow identical amounts with identical maturates from different lender and then exchange the interest repayment cash flow via an intermediary which may be a commercial bank

The currency swap operated in a similar fashion to the interest rate swap but each party becomes responsible for the others currency payments. The currency swap principle can therefore be used by borrowers to obtain currencies form which they are otherwise prevented because of excessive costs or foreign exchange risk

One must remember that the above list of variations on the basic bond market is not exhaustive. With growing uncertainty the number of new instruments also is growing. The nineties will definitely see much newer innovations compared to the eighties. Already, we have instruments like swap options, i.e., options on swaps.