Maestros

Financial institutions and security dealers use repurchase agreements or repos to obtain short term financing, usually on an overnight basis. Repos can also be used for longer periods, in which case they are called 'term repos'.

Under a repo arrangement the dealer seeking short term overnight funds will sell securities to an investor, simultaneously agreeing to repurchase the same securities back the next day at a price higher than the sale price. The difference between the two prices provides the effective interest to the investor supplying the funds.

A repo is in essence a short-term loan, with the securities involved serving as collateral on the loan. Repos are considered relatively safe as the securities (generally government securities) serve as collateral on the loan. While most repo transactions do not entail the transfer of the securities, investors can if they desire, protect themselves by taking delivery of the securities.

Repos are also used by central banks to regulate money supply in the economy. In Saudi Arabia repo agreements are made between banks and SAMA, where Saudi Arabian Monetary Agency (SAMA) acts as lender and the commercial bank, as the borrower, in need of liquidity.

3.2 CAPITAL MARKET INSTRUMENTS

Learning Objective 3.2 – Understand the characteristics, settlement periods, coupons/dividends, terms and maturities (where appropriate) of the following capital market instruments:

Corporate Bonds

Preferred stock (Preferred shares)

Common stocks(Ordinary shares)

Capital market instruments exist in the form of bonds and stock (or shares).

Bonds

Bonds represent debt claims issued in return for borrowing by corporations and governments. A bond is a contract between the issuer (the borrower of funds) and the buyer (the lender or investor of funds) of the bond. Under this contract, the second buyer lends a certain sum to the issuer, who agrees to repay the principal and agreed upon interest at specified dates. The contract may contain other conditions to protect the lender such as pledging certain assets as collateral, in which case the bond is called a mortgage bond or secured bond. Bonds issued by corporations and businesses are called Corporate Bonds, while those issued by the government are either called Treasury Bonds (T-Bonds) or Treasury Notes (T-Notes). Government bonds with maturities between 1 and 10 years are generally called T-notes while those with maturities longer than 10 years are called T- Bonds.

Three elements characterize a bond. The first is the maturity of the bond, which indicates the time period of the loan. The second is the face value or par value of the bond. This indicates the principal amount that the borrower agrees to repay at maturity. In the US most bonds have a par value of $1,000. The third element is the coupon rate expressed as a percentage of face value, indicating the periodic interest payments that the borrower promises to make over the life of the bond. Most bonds make semi-annual coupon payments. For example a SR1,000 face value, 10- year bond, with a coupon rate of 8%, promises to make payments of SR40 every six months (4% of SR1,000) for 10 years, and the face value of SR1,000 at the end of the tenth year. Given these three elements the investor decides on how much to pay for the bond. If the stated coupon rate is

higher than the interest rate that the investor desires he will be willing to pay more than the face value and the bond will trade at a premium. If the coupon rate is less than the interest rate that the investor demands, he will pay less than the face value and bond will trade at a discount. Finally, if the coupon rate matches the interest rate that the investor demands, the bond will trade at par. The interest rate or yield that the investor demands will depend on the general level of interest rates in the economy, the credit quality of the issuer, and any special features that the bond may carry Bonds can have a variety of features, some of which are described below:

Fixed vs. Floating Interest. Fixed rate bonds pay a fixed percentage of the par value of the bond

at regular intervals (normally every 6 months). Floating rate bonds on the other hand pay variable rates of interest which is determined by market interest rates (such as 6 month LIBOR) at the time of the periodic payment. A floating rate bond provides protection against interest rate risk. Bonds with a floating rate of interest are often referred to as floating rate notes.

Mortgage Bonds vs. Unsecured Bonds. A mortgage bond, or a bond with a fixed charge, has a

specific asset that collateralizes the loan and is therefore less risky for the investor. Sometimes, the issuer of the bond offers the investors a more general form of security over the assets of the issuer at the time - this is known as a 'floating charge'. If the issuer fails to make the required payments on the bond, the investors are able to take possession of the specified asset or assets and use them to recoup the money due. In contrast to the fixed or floating charge bonds, an investor in an unsecured bond is only a general creditor and may stand to lose his money in the event the company faces financial distress.

Asset-backed securities. Some bonds are issued to finance particular activities and are provided

with some form of security against the assets that the activities generate. An example might be a bond issue to finance the construction of a toll bridge, where the money to service and repay the bond is provided by the toll receipts, once the bridge is in operation. There are numerous other examples of asset-backed securities such as bonds issued by financial institutions backed by credit-card receivables and bonds issued by local authorities backed by parking fines.

Convertible Bonds. Convertible bonds are corporate bonds that give the buyer the option to

exchange their bonds for a specified number of shares in the company. For example a convertible bond with a conversion ratio of 5 implies that the bondholder may choose to exchange his bond for 5 shares of stock. Bondholders compare the value of the bond against the conversion value to decide on when to convert to shares. If the value of the bond is say SR980 and the market price of each share is SR180, it would not be profitable to convert, since the conversion value is only SR900 (5 x SR180). The excess of the bond's market price over conversion value is called the conversion premium, in this case SR80. If stock prices were to increase in the future it may be advantageous to convert the bond. Convertible bonds are commonly issued by startup firms that find it difficult to issue shares. Once the company succeeds, the share price tends to rise and bondholders are induced to convert. The company changes lenders into owners of the company, and reduce the company's debt Investors who buy convertible bonds have an opportunity to gain if the stock price of the firm increases. This perceived opportunity allows the company to issue these bonds with a lower coupon rate.