Investment Banking

Assignment

Submitted By: Zulkernain M. Kanjariwala

Submitted To: Prof. M. K. Varma

Date: 10-Oct-2010
Batch: 15th Finance
 Investment Banking

Q.1. Why Investment Banker are needed? What are their roles in the
Financial Market? Are they different from Commercial Bank?
Answer:
Investment Banker
An Investment Banker is total solutions provider as far as any corporate, desirous of
mobilizing capital, is concerned. The services range from investment research to investor
service on the one side and from preparation of offer documents to legal compliances and post
issue monitoring on the other. There exists a long lasting relationship between the Issuer
Company and the Investment Banker. A "Merchant Banker" could be defined as "An
organization that acts as an intermediary between the issuers and the ultimate purchasers of
securities in the primary security market"

Merchant Banker has been defined under the Securities & Exchange Board of India (Merchant
Bankers) Rules, 1992 as "any person who is engaged in the business of issue management
either by making arrangements regarding selling, buying or subscribing to securities as man-
ager, consultant, advisor or rendering corporate advisory service in relation to such issue
management".

As an Investment Banker, Companies provides;

 Management of Capital Issues

 Management of Buybacks, Takeovers and Delisting offers

 Private Placement of Debt and Equity

 Mergers and Amalgamations

 Loan Syndication

Role of Investment Banker

Investment banking assists as it performs IPO’s, private placement and bond offerings,
acts as broker and carries through mergers and acquisitions. Investment banks have
multilateral functions to perform.
Investment banking help public and private corporations in issuing securities in the primary
market, guarantee by standby underwriting or best efforts selling and foreign exchange
management.

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Other services include acting as intermediaries in trading for clients. Investment banking
provides financial advice to investors and serves them by assisting in purchasing securities,
managing financial assets and trading securities.

Investment Bank vs. Commercial Bank

A commercial bank may legally take deposits for checking and savings accounts from
consumers. The typical commercial banking process is fairly straightforward. You deposit
money into your bank, and the bank loans that money to consumers and companies in need of
capital (cash). Companies borrow to finance the growth of their company or meet immediate
cash needs. Companies that borrow from commercial banks can range in size from the dry
cleaner on the corner to a multinational conglomerate. The commercial bank generates a profit
by paying depositors a lower interest rate than the bank charges on loans. This is actually a
very safe way of conducting a profitable business.
An investment bank operates differently. An investment bank does not have an inventory of
cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an
intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds. If a
company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell
equity or debt (stocks or bonds).

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Q.2. “Primary Market is a Launching Pad of an IPO” – Explain. Why

company wants to get listed & go for Equity? Small brief on it &
Explain the role of different Agencies involved in Launching an IPO.
Answer:
Primary Market is a Launching Pad of an IPO:

Shares are bought and sold on the Share Market. The Share Market is like any other mar-
ket where buyers and sellers come together for the purposes of exchange. Fruit is bought and
sold in a fruit market and shares are bought and sold in the Share Market.
But shares need to be created before they can be bought or sold – so where do they come
from?

The Primary market: Primary means first

A primary market is the market for a security that is being issued for the first time.
Primary market investors buy securities directly from the issuer, not from each other.
The primary market is like a “launch pad” where companies that want to raise capital
(cash), issue shares (and other securities) to the public for the first time.
By listing on the Share Market the company is saying, “If you give us some cash, we will give
you part ownership in our company and as proof of your ownership we will provide you with shares”

Why company wants to get listed & go for Equity?.

When a privately held corporation needs additional capital, it can borrow cash or sell
stock to raise needed funds. Or else, it may decide to “go public”. "Going Public" is the best
choice for a growing business for the following reasons:
 The costs of an initial public offering are small as compared to the costs of
borrowing large sums of money for ten years or more.
 The capital raised never has to be repaid.
 When a company sells its stock publicly, there is also the possibility for
appreciation of the share price due to market factors not directly related to the company.
 It allows a company to tap a wide pool of investors to provide it with large
volumes of capital for future growth

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Agencies involved in Launching an IPO.

To Launch an IPO, various intermediaries are playing vital role. When a company
launches an IPO inviting the public to buy its shares, it has to appoint various intermediate
people who will enable them successfully complete the issue process. They are:

1. Book Running Lead Managers (BRLMs)

2. Bankers for the Issue
3. Underwriters
4. Registrars etc...

Book Running Lead Managers:

The Company issuing shares appoints the BRLM or the Lead Merchant Bankers. The role
of the BRLM can be divided into two parts, viz., Pre Issue and Post Issue.
The Pre Issue role includes compliance with the stipulated requirements of SEBI and other
regulatory authorities, completion of formalities for listing of the shares on the Stock
Exchanges (NSE or BSE in India) appointing of various agencies like advertising agencies,
printers, underwriters, registrars, bankers etc.
The Post Issue activities include management of escrow accounts (The bank accounts where
the money from all share applicants will get deposited), deciding the final share issue price,
share allotment to applicants, ensuring proper refund to unsuccessful applicants, allotment
letters and ensuring that each agency is carrying out their requisite functions properly and by
abiding by the laws laid down by SEBI for an IPO process.

Bankers to the Issue:

Bankers to the issue, as the name suggests are the people who carry out all banking
activities like accepting the money from the applicants, transfer of funds to the promoters and
transfer of refunds to unsuccessful applicants.

Registrars:
The Registrar finalizes the total list of all applicants and comes up with the list of eligible
applicants after deleting all invalid applications. Then he ensures that shares are credited to
the allotters accounts and refunds are sent to unsuccessful applicants.
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Underwriters to the Issue:

Underwriters are the institutions/individuals who agree to buy the shares of the
company in case the company is unable to sell all its shares to the public. For providing this
safety, the underwriters charge a commission to the company for providing this service.

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Q.3 Write notes on Any Three

1. QIB
2. Price Band
3. Venture Capital
4. Private Equity
5. Divestiture
6. FIIs

Answer:
1. QIB
Qualified Institutional Buyers are those institutional investors who are generally perceived to
possess expertise and the financial muscle to evaluate and invest in the capital markets. In
terms of clause 2.1.zd of ICDR Guidelines, a ‘Qualified Institutional Buyer’ shall mean:
 A mutual fund, venture capital fund and foreign venture capital investor registered
with the Board;
 A foreign institutional investor and sub-account (other than a sub-account which is a
foreign corporate or foreign individual), registered with the Board;
 A public financial institution as defined in section 4A of the Companies Act, 1956;
 A scheduled commercial bank;
 A multilateral and bilateral development financial institution;
 A state industrial development corporation;
 An insurance company registered with the Insurance Regulatory and Development
Authority;
 A provident fund with minimum corpus of twenty five crore rupees;
 A pension fund with minimum corpus of twenty five crore rupees;
 National Investment Fund set up by resolution no. F. No. 2/3/2005-DDII dated
November 23, 2005 of the Government of India published in the Gazette of India;

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2. Price Band
The prospectus of the issuer company may contain either the floor price for the securities or a
price band within which the investors can bid for the shares. The spread between the floor
(minimum) and the cap (maximum) of the price band shall not be more than 20 per cent. The
price band can be revised and such a revision shall be informed to the investors by informing
the stock exchanges, by issuing press etc. In case the price band is revised, the bidding period
need to be extended for a further period of three days, subject to the total bidding period not
exceeding thirteen days.

How is the Price Band decided?

Price Band is decided by the issuer company in consultation with Merchant Bankers keeping
the various factors about the issuer company in mind. The basis of issue price is disclosed in
the offer document. The issuer is required to disclose in detail about the qualitative and
quantitative factors taken into account in arriving the price band.

3. Venture Capital
The object of the venture capital financing is to invest in high-risk projects with the
anticipation of high returns. The funds are invested in such growing enterprises, where the
ideas are there but the conventional funding from banks, financial institutions are not
available. This is because that these enterprises do not have collateral to offer. These types of
enterprises are usually first generation enterprises.

Venture capital fund is a fund formed as a trust or a company under the regulations which

 Raised in the specified manner and

 Invested in venture capital undertaking
 Has dedicated pool of capital
Venture Capital undertaking is domestic company,

 Whose shares are not listed

 Which is in the business for providing services, production or manufacturing of articles
which are not in the negative list
 Each scheme launched or fund set up by a venture capital fund shall have firm
commitment from the investors for contribution or an amount or at least Rupees five crore
before the start of operations by the venture capital fund

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Negative list covers following activities:

 Non-banking financial services [excluding those Non – Banking Financial companies

which are registered with Reserve Bank of India and have been categorized as Equipment
Leasing or Hire Purchase companies.
 Gold financing [excluding those companies, which are engaged in gold financing for
jewelry.
 Activities not permitted under the Industrial Policy of Government of India
 Any other activity which may be specified by the SEBI.

Venture capitalists generally:

 Finance new and rapidly growing companies
 Purchase equity securities
 Assist in the development of new products or services
 Add value to the company through active participation
 Take higher risks with the expectation of higher rewards
 Have a long-term orientation

Investment in India by Venture capitalists

Given hereunder is the list of sectors where the investment is usually made by the venture
capital companies.

1. IT and IT-enabled services

2. Software Products (Mainly Enterprise-focused)

3. Wireless/Telecommunication/Semiconductor

4. Banking

5. PSU Disinvestments

6. Media/Entertainment

7. Bio Technology/Bio Informatics

8. Pharmaceuticals

9. Electronic Manufacturing

10. Retail

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4. Private Equity
There is no universally agreed definition of private equity. Different academic studies and
private equity associations in various economies have defined private equity differently
depending on the activities they engage in those economies.
 Lerner (1999) broadly defines private equity organization as partnerships specializing in
venture capital, leveraged buyouts (LBOs), mezzanine investments, build-ups, distressed debt
and other related investments.
 Fenn, Liang and Prowse (1995) have described them as ‘financial sponsors’ acquiring
large ownership stakes and taking an active role in monitoring and advising portfolio
companies.
 Ljungqvist and Richardson (2003) describes private equity as an illiquid investment since
there is no active secondary market for such investments, investors have little control over
how capital is invested and the investment profile covers a long horizon.
The European Venture Capital Association defines private equity as the provision of equity
capital by financial investors – over the medium or long-term – to non-quoted companies with
high growth potential. It is also called ‘patient capital’ as it seeks to profit from long term
capital gains rather than short term regular reimbursements.
Similarly, the International Financial Services, London calls any type of equity investment in
an asset in which the equity is not freely tradable on a public stock market as private equity.
Private equities are generally less liquid than publicly traded stocks and are thought of as a
long term investment.

Activities of PE
 Seed Financing: Providing small sums of capital necessary to develop a business idea.
 Start-up financing: Providing capital required for product development and initial
marketing activities.
 First-stage: Financing the commercialization and production of products.
 Second-stage: Providing working capital funding and required financing for young firms
during growth period.
 Third-stage: Financing the expansion of growth companies.
 Bridge financing: Last financing round prior to an initial public offering of a company.

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 PIPE deals: A private investment in public equity, often called a PIPE deal, involves the
selling of publicly traded common shares or some form of preferred stock or convertible
security to private investors.
 Leveraged Buyout (LBO): It entails the purchase of a company by a small group of
investors, especially buyout specialists, largely financed by debt.
 Management Buyout (MBO): It is a subset of LBO whereby incumbent management is
included in the buying group and key executives perform an important role in the LBO
transactions.

5. FIIs – Foreign Institutional Investor

Foreign institutional investor means an entity established or incorporated outside India
which proposes to make investment in India. Positive tidings about the Indian economy
combined with a fast-growing market have made India an attractive destination for foreign
institutional investors. These entities are required to be registered with SEBI as FIIs.
As per SEBI regulations, a FII cannot invest more than 10 per cent of total issued capital
of an Indian company. These prescribed limits are subjected to the overall limit of 24-49 per
cent or the sectoral limit as prescribed by the Government of India/Reserve Bank of India.
Incorporated Entity
 By incorporating a company under the Companies Act,1956 through
 Joint Ventures; or
 Wholly Owned Subsidiaries
Foreign equity in such Indian companies can be up to 100% depending on the requirements of
the investor, subject to equity caps in respect of the area of activities under the Foreign Direct
Investment (FDI) policy.
Unincorporated Entity
As a foreign Company through
 Liaison Office/Representative Office
 Project Office
 Branch Office
Such offices can undertake activities permitted under the Foreign Exchange Management
Regulations, 2000.

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Q.4. Secutrization let to major Financial Debacle in Europe &

America” – Explain. Explain Secutrization in details.
Answer:
Secutrization:
Traditionally the world over, commercial banks have been performing the role of finan-
cial intermediation by lending to corporate in the form of loans or subscribing to their debt is-
suances thereby taking direct exposures on the overall credit risks of the underlying borrow-
ers. It is critical to understand that credit risk is a culmination of different factors such as in-
dustry risk, business risk, financial risk, project risk and management risk faced by the under-
lying borrowing corporate, some of which can be within the corporate control while the others
are not. Therefore, quite often, banks end up taking lending decisions without fully under-
standing and appreciating the nature of the multiple risks that represent the borrowing organ-
izations.

The development of securitization was thus premised on credit being converted into a
commodity. In the process, the risk inherent in credits was being professionally measured and
rated. As a logical follow-up, if the risk could be measured and traded as a commodity with
the underlying financing involved, the financing and the credit could be stripped as two dif-
ferent products and the risk could be undertaken by guaranteeing the total expected return
from the credit transaction. This led to the development of credit derivatives.

Further, as more cash flows loans were being securitized, often gaps got created between
the new asset-based deal and the amount financed previously for two primary reasons:
1. Receivables and assets being discounted at rates greater than in the past for fear
that their values will not be realized in the future, and
2. Banks placing ceilings on the amount of total debt a company can obtain as a res-
ult of defaults and regulatory pressure.

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Key Concept
Securitization is a process through which homogenous illiquid financial assets are pooled
and repackaged into marketable securities. Generally, the assets are held in a bankruptcy re-
mote vehicle termed as a Special Purpose Vehicle (SPV) or are otherwise secured in a manner
that gives the investors a first ranking right to those assets.

The intent of securitization typically is to ensure that repayment of the securities issued
to investors is dependent upon the securitized assets and therefore will not be affected by the
insolvency of any other party including the entity securitizing the assets. Most securitization
issues are rated by an accredited credit rating agency. The rating applies to the securities that
are issued to investors and indicates the likelihood of payment of interest and payment of
principal in full and on time.

Securitization involves isolation of specific risks, evaluation of the same, allocating the
risks to various participants in the transaction (based on who is best equipped to mitigate the
respective risks), mitigating the risks through appropriate credit enhancement structures and
pricing the residual risk borne by the originator. It entails evaluating the transaction from the
legal, regulatory, taxation and accounting implications from the perspective of various parti-
cipants.

In a securitization transaction, the assets to be securitized are transferred by the asset

owner (the originator or transferor) to a special purpose vehicle (SPV) as the asset purchaser.
The SPV may be a corporation, trust or other independent legal entity. The SPV issues securit-
ies to public or private investors, which are backed (i.e. secured) by the income flows gener-
ated by the assets securitized and sometimes also by the underlying assets themselves. The net
proceeds received from the issuance of the securities are used to pay the transferor for the as-
sets acquired by the SPV.

Securitization transactions deal with various asset classes that include, among others,
mortgages, automobile loans, aircraft, equipment and municipal leases, credit card receiv-
ables, hospital, retail, royalty and trade receivables, real estate, purchase contracts for natural
resource assets such as oil, gas and timber, student and home equity loans, etc., and has

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emerged as an efficient and cost-effective efficiency resource raising mechanism with the po-
tential to integrate the apparently illiquid underlying assets with the capital markets.

From an originator’s perspective, the main advantages of securitization include the abil-
ity to raise finance at a relatively low cost, partial or total removal of assets from its balance
sheet, diversification of funding sources, access to the capital markets for unrated entities and
access to liquidity. Thus it serves as an effective balance sheet management tool for originat-
ors, through which hidden values could be identified and unlocked, asset-liability mismatch,
currency, commodity and interest rate risks could be hedged and an enhanced return on capit-
al and equity could be managed through the continuous churning of portfolio. Additionally,
banks that raise funds through securitization are able to reduce their regulatory, and some-
times economic, capital requirements.

From an investor’s perspective, securitization offers an alternative investment medium

which, for a given rating level, usually offers a safer investment avenue and higher risk-adjus-
ted returns compared to equivalent rated bank or corporate debt.

Depending on the originator’s financing requirements, and the characteristics of the un-
derlying assets, funding can be arranged through term securities, balance sheet warehouse fa-
cilities or asset backed commercial paper.

Participants:
The following parties are involved in a typical securitization transaction:
 Originator: This is the entity which requires the financing and hence drives the
deal. Typically the Originator owns the assets or cash flows around which the transaction
is structured.
 SPV (Special Purpose Vehicle): An SPV is typically used in a structured transaction
for ensuring bankruptcy remoteness from the Originator. The SPV is the issuer of securit-
ies. Typically the ownership of the cash flows or assets around which the transaction is
structured is transferred from the Originator to the SPV at the time of execution of the
transaction. The SPV is typically an entity with narrowly defined purposes and activities
and usually has independent trustees/directors. The SPV needs to be capital efficient (i.e.
nominally capitalized) and tax efficient (i.e. multiple taxation should be avoided).

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 Investors: The investors are the providers of funds and could be individuals or insti-
tutional investors like banks, financial institutions, mutual funds, provident funds, pen-
sion funds, insurance companies, etc.
 Obligor(s): The Obligor is the Originator’s debtor. The amount outstanding from the
Obligor is the asset that is transferred to the SPV. The credit standing of the Obligor(s) is
of paramount importance in a securitization transaction.
 Guarantor / Credit Protection Provider / Insurer: These are entities that provide pro-
tection to the Investor for the investment made in the securities and the returns thereon
against identified risks. Typically, on the happening of pre-identified events, affecting
the underlying assets or cash flows, or the payment ability of the Obligors, these entities
pay moneys that are passed on to the Investor.

Besides these primary parties, the other parties involved in a typical securitization deal are:
 Rating Agency: Since structured finance deals are generally complex with intricate
payment structures and legal mechanisms, rating of the transaction by an independent
qualified rating agency plays an important role in attracting Investors.
 Administrator or Servicer: The Servicer performs the functions of collecting the
cash flows, maintaining the assets, keeping records and general monitoring of the Oblig-
ors. In many cases, especially in the Indian context, the Originator also performs the role
of the Servicer.
 Agent and Trustee: The Trustee is the manager of the SPV and plays a key role in
the transaction. The trustee generally administers the transaction, manages the inflow
and outflow of moneys, and does all acts and deeds for protecting the rights of the In-
vestors, including initiating legal action against various participants in case of any breach
of terms and triggering payment from various credit enhancement structures etc.
 Structurer: Normally, an investment banker acts as the Structurer and designs and
executes the transaction. The Structurer also brings together the originator, credit protec-
tion provider, the investors and other parties to a deal. In some cases the Investor also
acts as the Structurer.

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Classification:
Securitization can be classified into two categories:
1. Asset backed securitization, and
2. Future flow securitization

Asset backed securitization (ABS):

Typical ABS receivables are mortgage-backed receivables, auto pool receivables, collater-
alized debt obligations (CDO) and hire purchase rental receivables with the originator’s re-
sponsibility limited to collection of the underlying receivables only. Hence, ABS transactions
can be bankruptcy remote to the originator as the SPV or the investors can continue to collect
from the underlying obligors even if the originator ceases to exist, and can be rated independ-
ent of the rating of the Originator.

Future Flow Securitization (FFS):

This refers to securitization of receivables which are to be generated in the “future” i.e.
the obligation of the obligor to make payments depends on further substantial performance by
the originator. Trade Receivables, arising out of long-term off take contracts between originat-
or and obligor for sale/purchase of products over a pre-determined period in future, typically
qualify as future receivables. Other typical FFS receivables are credit card receivables, electri-
city receivables, toll road receivables, etc.

In both ABS and FFS transactions, the other principal characteristics that need to be eval-
uated are as follows:
 Type of underlying security attached - movable or immovable in nature
 Ability to estimate the cash flows from the asset
 Payment frequency and the propensity to prepay or make delayed payments
 Nature of the obligor(s) on whom cash flows are dependent

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USA Market’s Secutrization Experience:

The securitization market in the US has a fairly long vintage, with the Federal Govern-
ment supporting the MBS market through institutions like the Freddie Mac, Fannie Mae and
Ginnae Mae. Over the last quarter of a century, securitization has become one of the largest
sources of debt financing in the US representing around 30% of the total outstanding US bond
market and is enjoying extraordinary growth. Between 1996 and 2004, the market grew at an
average rate of 19% per annum from US$ 152 billion (in 1996) to US$ 624 billion (in 2004). In
fact, the growth rate has been showing an up trend in the recent past with the CAGR between
2001 and 2004 being 28%. Despite being the most matured market, traditional asset classes
such as the MBS (72%) and ABS including CDOs (14%) have driven the volumes in the US, the
balance being contributed by FFS transactions (credit cards, student fees, etc.). In 2005, the
market issuances till date gross up to US$ 176 billion (as compared to US$ 167 billion achieved
during the same period in 2004). The share of the traditional asset classes like MBS stands at
70% with ABS including CDOs contributing to around 19% of the issuance volumes.

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Europe Market’s Secutrization Experience:

European securitization market began in the mid 1980s with UK leading the way with an
MBS issue in 1986. For a long period, issuance volumes were modest with UK and France be-
ing the dominant markets. Bulk of the volumes was accounted for by traditional MBS and
ABS (mainly CDOs) transactions. However, at present, Europe provides a thriving securitiza-
tion market. Between 1997 and 2003, the market grew at an average rate of 23% per annum
from US$ 66 billion (in 1997) to US$ 285 billion (in 2004). In fact, the growth rate for the
European market between 2001 and 2004 being 39% much exceeds the growth rate of the US
markets during the same period. In 2005, the year to date volumes of securitized paper
amount to US$ 71.5 billion as against US$ 72.6 billion in the corresponding period in 2004.
MBS (60%) and ABS including CDO (28%) continue to dominate the issuances in Europe. In
terms of countries of origin, UK leads the pack with a market share of around 45%, followed
by Italy with a share of around 14%, while Spain and Netherlands have around 8% share each.
Other significant countries of origin are Germany and France. In terms of currencies of issu-
ance, around 64% of the issuances are Euro denominated, around 21% are denominated in
GBP while the remaining are denominated in US$.

Reason for major financial debacle in Europe and US:

First, a regulated and authorized financial institution originates numerous mortgages,
which are secured by claims against the various properties the mortgagors purchase. Then, all
of the individual mortgages are bundled together into a mortgage pool, which is held in trust
as the collateral for an MBS. The MBS can be issued by a third-party financial company, such a
large investment banking firm, or by the same bank that originated the mortgages in the first
place. Mortgage-backed securities are also issued by aggregators such as Fannie Mae or
Freddie Mac.
Asubprime mortgage is a type of loan granted to individuals with poor credit histories
(often below 600), who, as a result of their deficient credit ratings, would not be able to qualify
for conventional mortgages. Because subprime borrowers present a higher risk for lenders,
subprime mortgages charge interest rates above the prime lending rate.

Many lenders were more liberal in granting these loans from 2004 to 2006 as a result of
lower interest rates and high capital liquidity. Lenders sought additional profits through these
higher risk loans, and they charged interest rates above prime in order to compensate for the
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additional risk they assumed. Consequently, once the rate of subprime mortgage foreclosures
skyrocketed, many lenders experienced extreme financial difficulties, and even bankruptcy.

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Q.5. Who can issue “Bonds”? Why bonds differ from Shares? Why
bond price fluctuate?
Answer:
Definition:
Bond is a debt instrument issued for a period of more than one year with the purpose of
raising capital by borrowing. Generally, a bond is a promise to repay the principal along with
interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all
bonds require a repayment of principal.

Who can issue “Bonds”?

The Government, states, cities, corporations, and many other types of institutions sell bonds.
When an investor buys a bond, he/she becomes a creditor of the issuer.
Bonds are often divided into different categories based on tax status, credit quality, issuer
type, maturity and secured/unsecured (and there are several other ways to classify bonds as
well).
A riskier bond has to provide a higher payout to compensate for that additional risk. Some
bonds are tax-exempt, and these are typically issued by municipal, county or state
governments, whose interest payments are not subject to federal income tax, and sometimes
also state or local income tax.

Why “Bonds” differ from “Shares”?

Bonds are debt, whereas stocks are equity. This is the important distinction between the two
securities.
By purchasing equity (stock) an investor becomes an owner in a corporation. Ownership
comes with voting rights and the right to share in any future profits.
By purchasing debt (bonds) an investor becomes a creditor to the corporation (or
government).
The primary advantage of being a creditor is that you have a higher claim on assets than
shareholders do: that is, in the case of bankruptcy, a bondholder will get paid before a
shareholder.
However, the bondholder does not share in the profits if a company does well - he or she is
entitled only to the principal plus interest.
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Why “Bonds” price fluctuate?

Many are the factors that influence directly price fluctuations of bonds. These factors include
the relation among prices of bonds, coupon rates, market yields, maturities and risk
assessment.
The following axioms illustrate this relation:
 The coupon rate relative to market rates of interest. When the rate of interest boosts in
the market, and surpass the coupon rate of a bond, the price of such bond will fall so as to
resemble the current yield at the market’s interest rate. When the rates of interest drop, prices
of bonds go up. While lesser the coupon rate of a bond, greater will price fluctuations be.
 The length of time to maturity. While greater the maturity, more volatile will price
fluctuations be.
 For a given change in a bond’s yield. Longer times to maturity of the bond greater will
the magnitude of changes in a bond’s yield be.
 For a given change in a bond’s yield. The size of the shifts in prices of bonds increase at
a decreasing rate depending on the time to maturity of the bond.
 For a given change in the bond’s yield. The magnitude of the prices of bonds is
inversely related to the bond’s yield.
 For a given change in the bond’s yield. The magnitude of the price increase caused by a
decrease in yield is greater than the price decrease caused by an increase in yield.
 Changes in risk assessment by the market. While lower the quality of a bond, lower is
the price. While higher the quality of the bond higher the price. The greater the risk of the
bond, the more volatile will be the bond’s price fluctuations.

Prepared By: Zulkernain M Kanjariwala Page: 21 of 21