Equity financing

Equity financing is the process of raising capital through the sale of shares. Companies raise money because they might have a short-term need to pay bills or they might have a long-term goal and require funds to invest in their growth. By selling shares, they sell ownership in their company in return for cash, like stock financing.

Equity financing comes from many sources; for example, an entrepreneur's friends and family, investors, or an initial public offering (IPO). Industry giants such as Google and Facebook raised billions in capital through IPOs.

Equity risk is "the financial risk involved in holding equity in a particular investment". Equity risk often refers to equity in companies through the purchase of stocks, and does not commonly refer to the risk in paying into real estate or building equity in properties.

The measure of risk used in the equity markets is typically the standard deviation of a security's price over a number of periods. The standard deviation will delineate the normal fluctuations one can expect in that particular security above and below the mean, or average. However, since most investors would not consider fluctuations above the average return as "risk", some economists prefer other means of measuring it.

Bond financing 

Bond financing is a type of long-term borrowing that state and local governments frequently use to raise money, primarily for long-lived infrastructure assets. They obtain this money by selling bonds to investors. In exchange, they promise to repay this money, with interest, according to specified schedules. International bonds

International bonds are debt instruments that are issued by a non-domestic company in order to raise money from international investors and are usually denominated in the currency of the issuing country with the primary objective to attract more investors on a large scale.

Types of International Bonds

  1. Foreign bonds and Euro bonds
  2. Global bonds
  3. Straight Bonds
  4. Floating-rate Bond
  5. Floating- rate Bonds
  6. Convertible bonds
  7. Cocktail bonds

i)  Foreign bonds and Euro bonds

Foreign Bond is a bond where foreign company issues bond denominated in the currency denomination of the foreign country. For example, an US company issues bond and raises capital in Japan denominated in Japanese Yen. In other words, the Japanese investors are not exposed to foreign exchange risk while investing in a foreign bond. At this junction it is important to understand that a Japanese company may also issue bond and raise capital in Japan denominated in Japanese Yen. But bonds issued by the Japanese company are termed as ‗Domestic Bond‘. In case of a foreign bond, the bond issuer is from a foreign country. An Indian company issuing USD bond in any country belonging to Middle East region is an example of foreign bond.

In Euro bond, a foreign company issues a bond denominated in a currency which is not the home currency of the investors. For example, an US company issues bond and raises capital in Japan denominated in US Dollar. This will be an example Euro Bond. If the US company issues bond in Pound sterling in Japan, it will also be considered as Euro Bond. In the earlier case, it would be considered as a Euro Dollar Bond while in the later case, it would be known as Euro Sterling Bond. Historical development of Eurobond market is attributed to the unfavorable tax regime in USA during 1960s. This forced companies to issue USD denominated bond outside USA. The First Eurobond was done in 1963.

ii)  Global bonds

Though very few companies have issued these bonds. In a global bond issue, the issuer offers the bonds to investors of many countries at one go. Normally these bonds are denominated in multiple currencies. Global bonds are normally issued by large multinational or transnational companies or as sovereign bonds. Global bonds can have following differences among issuer, denomination and the country in which it is being issued:

  • Issuer (Issuing company‘s nationality)
  • What is the denomination of bonds (currency) and for which country this currency is local?
  • The country in which it is being issued

An example would be an Australian Bank (A) issuing a GBP Bond (B‘s currency) in London (B‘s country) and in Japan (C).

These bonds are large

  • Possess high ratings
  • Issued for simultaneous placement in various nations
  • Traded in various regions on the basis of home market

Global bonds are sometimes also called Eurobonds but they have additional features. A Eurobond is an international bond that is issued and traded in countries other than the country in which the bond‘s currency or value is denominated. These bonds are issued in a currency that is not the domestic currency of the issuer.

iii)  Straight Bonds

A straight bond is a bond that pays interest at regular intervals, and at maturity pays back the principal that was originally invested. A straight bond has no special features compared to other bonds with embedded options. U.S. Treasury bonds issued by the government are examples of straight bonds. A straight bond is also called a plain vanilla bond or a bullet bond.

The features of a straight bond include constant coupon payments, face value or par value, purchase value, and a fixed maturity date. A straight bondholder expects to receive periodic interest payments, known as coupons, on the bond until the bond matures. At maturity date, the principal investment is repaid to the investor. The return on principal depends on the price that the bond was purchased for. If the bond was purchased at par, the bondholder receives the par value at maturity. If the bond was purchased at a premium to par, the investor will receive a par amount less than his or her initial capital investment. Finally, a bond acquired at a discount to par means that the investor‘s repayment at maturity will be higher than his or her initial investment.

Types of straight bond

a) Bullet-redemption bond

A bullet bond is a debt instrument whose entire principal value is paid all at once on the maturity date, as opposed to amortizing the bond over its lifetime. Bullet bonds cannot be redeemed early by an issuer, which means they are non-callable.

b) Rising coupon bond

A bond with interest coupons that change to preset levels on specific dates. More specifically, the bond pays a given coupon for a specific period of time, and then its coupon is stepped up in regular periods until maturity. For instance, a bond may pay 6% interest for the next five years, and thereafter interest payment increases by an additional 2% every next five years until the bond matures. Typically, issuers embed rising-coupon bonds with call options which give them the right to redeem the bonds at par on the date the coupon is set to step up.

This bond is also known as a dual-coupon bond, a stepped-coupon bond, or a step-up coupon bond.

c) Zero-coupon bond

A zero-coupon bond is a debt security that does not pay interest but instead trades at a deep discount, rendering a profit at maturity, when the bond is redeemed for its full face value.

Some bonds are issued as zero-coupon instruments from the start, while others bonds transform into zero-coupon instruments after a financial institution strips them of their coupons and repackages them as zero-coupon bonds. Because they offer the entire payment at maturity, zero-coupon bonds tend to fluctuate in price, much more so than coupon bonds.

A zero-coupon bond is also known as an accrual bond.

d) Bonds with currency option

The investor possesses the right for receiving the payments in a currency except the currency of issue

e) Bull and bear bonds

A bull bond is a term used to refer to a bond that is likely to increase in value in a bull market. Most bonds tend to increase in value when interest rates decline, but bull bonds refer to types of bonds that do especially well in this environment. A bull bond is a specific type of bond that performs well in a bull market. The bull bond increases as interest rates decline, which distinguishes it from many other types of bonds, most of which tend to increase in price when interest rates are rising.

A bull market is a financial market marked by optimism and investor confidence. The term bull market, associated with trading in the stock market, can also apply to anything traded, such as bonds, currencies, and commodities.

4) Floating-rate Bonds

  • Floating rate bonds pay coupon based on some reference interest rate, such as LIBOR.
  • Unlike coupon bonds, floating rate notes do not carry a fixed nominal interest rate.
  • The coupon payments are linked to the movement in a reference interest rate (frequently money market rates, such as the LIBOR) to which they are adjusted at specific intervals, typically on each coupon date for the next coupon period.
  • The coupon of a floating rate bond is frequently defined as the sum of the reference interest rate and a spread of x basis points.
  • Floating rate bonds may be viewed as zero coupon bonds with a face value equaling the sum of the forthcoming coupon payment and the principal because their regular interest rate adjustments guarantee interest payments in line with market conditions

A floating rate note (FRN) is a debt instrument whose coupon rate is tied to a benchmark rate such as LIBOR or the US Treasury Bill rate. Thus, the coupon rate on a floating rate note is variable. It is typically composed of a variable benchmark rate + a fixed spread.

The rate is adjusted monthly or quarterly in relation to the benchmark. The maturity period of FRN‘s vary but are typically in the range of two to five years.

FRN‘s are issued by governments, as well as private companies and financial institutions. The notes are typically traded over-the-counter.

Example of a Floating Rate Note

A bank might issue the following floating rate note:

Principal: $1,000

Interest Rate: Federal Funds Rate +0.25 Reset Period: Three months

Maturity: Five years

This note would have a face value of $1,000. In five years the note will mature and will repay that principal. During that five years the note will have an interest rate set at the Federal Reserve‘s interest rate plus 0.25. For example, if the Federal Reserve rate was 2.5%, this note would bear an interest of 2.75%.

Every three months, timed to the quarterly Federal Reserve meeting, the note will update its interest rate. If the Federal Reserve rate has changed, this note will update its interest rate to match. For example, say at the board‘s next meeting the Federal Reserve rate falls to 2%. This floating rate note, at its next reset date, would take on an interest rate of 2.25%.

FRNs are present in various forms:

a) Perpetual FRNs

A floating-rate note (FRN) whose principal never matures, i.e., it doesn't have a redemption payment and only makes perpetual coupon payments, which are reset periodically on a fixing date by reference to a benchmark rate such as 3- or 6-month LIBOR. This instrument delivers floating-rate cash flows as long as the issuer remains in business (virtually, forever). The coupon is reset and paid on a periodic basis by adding a specific spread to the reference rate.

Perpetual FRNs are conventionally relied upon by financial institutions, such as banks, as a source of primary capital. In other words, although perpetual FRNs are essentially debt instruments, the perpetual feature bestows on them the nature of equity. In general, perpetual FRNs are classified by financial institutions as equity or quasi-equity.

A perpetual FRN is also referred to as a perpetual floater.

b) Minimax FRNs

A floating-rate note (FRN) which has a minimum and a maximum interest rate, i.e., an embedded collar. This collar has the effect of limiting the reference rate to minimum and maximum values so that the holder can confine fluctuations in the reference rate to a specific range (a lower and an upper boundary). A mini-max FRN is also known as a mini-max floater or a collared FRN.

c) Drop Lock FRNs\Flip-flop FRN

A floating-rate note (FRN) which has a rate trigger allowing the interest to convert to a specified fixed rate for the remaining life of the underlying debt instrument should the floating rate reaches or drops below a pre-determined level on an interest fixing (resetting) date or on a number of consecutive fixing dates. For example, a drop-lock feature may be added to a loan so that the lender can convert the floating rate to a fixed rate if the benchmark index hits a specified floor. A drop-lock FRN is also referred to as a drop-lock floater.

d) Flip-flop FRN

A floating-rate note (FRN) that gives the bondholder the right to convert a note with a long maturity date or no maturity (no redemption date) into a note with a short maturity date. Furthermore, the bondholder has the right to convert back into the original note before the short-dated note reaches maturity. The short- dated note typically pays a lower spread over its floating rate (LIBOR) than the the long-dated note, but this is compensated for in the possibility of receiving principal repayment by the bondholder much earlier. A flip-flop FRN is also known as a flip-flop floater.

e) Mismatch FRN

A floating-rate note (FRN) in which the coupon is payable after more than one coupon period. That is the interest rate is refixed on a more times than the interest is paid. In this sense, a mismatch FRN differs from a standard FRN in that the dates of coupon rate refixes and coupon payment dates are not the same. For example, a coupon payment may be made after three consecutive monthly refixes. However, the rate will still be based on the six-month (or three-month) interest rate linked to the payment frequency. A mismatch FRN is also known as a mismatch floater.

f) Hybrid Fixed Rate Reverse Floating Rate Notes

A floating-rate note (FRN) that pays a high fixed rate coupon for an introductory period (first one or two years), then it pays the difference between an even higher fixed rate coupon and a floating reference rate (LIBOR). For example, this floating-rate note can be structured as follows:

Over the first two years: it pays 10%.

From the third year on, it pays: 15% - LIBOR.

Investors who expect short-term rates to fall in a future period can earn very large coupons. However, if such expectations are off-the-mark, huge losses would result.

iv) Convertible Bonds

Convertible bonds are corporate bonds that can be converted by the holder into the common stock of the issuing company. a convertible bond gives the holder the option to convert or exchange it for a predetermined number of shares in the issuing company. When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate.

Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles. If the stock performs poorly, there is no conversion and an investor is stuck with the bond's sub-par return-below that a non-convertible corporate bond would get. As always, there is a tradeoff between risk and return.

v) Cocktail bonds

Composite currency bonds are denominated in a currency basket, such as SDRs or ECUs, instead of a single currency. They are frequently called currency cocktail bonds. They are typically straight fixed-rate bonds. The currency composite is a portfolio of currencies: when some currencies are depreciating others may be appreciating, thus yielding lower variability overall.