The Investment Industry for IT Practitioners E-Book

Andrew Bradford

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: SII Series on Financial Services Operations
• Sprache: Englisch

Seitenzahl: 648

Veröffentlichungsjahr: 2012

Beschreibung

Giving IT professionals in financial services firms a rounded and comprehensive grounding in their knowledge of their industry, this book offers a primer on the major financial instruments, transactions, and processes, as well as a sound knowledge of the principles of good IT management in the industry. The book gives readers a clear understanding of equities, bonds, currencies, listed derivatives and OTC derivatives. It explains transactions in those instruments and the requirements of business systems that process these transactions. Transactions covered include (inter-alia) agency and principal purchases and sales, loans and deposits, repos and reverse repos, stock loans; and also the Sharia-compliant 'Islamic' transactions that may be used as alternatives to interest bearing transactions. Andrew Bradford gives an introduction to how investment firms are regulated; offers an understanding of the STP (Straight-through-Processing) concept following the trade cycle for the transactions from order through to execution through pre-settlement to final settlement; covers basic accounting procedures for the transactions; and conveys the basic principles of good IT management in the investment industry.

Leseprobe

Contents

Cover

Half Title page

Title page

Copyright page

Dedication

Introduction

How to Use this Book

Acknowledgements

Part One: Investments and Securities Explained

Chapter 1: An Introduction to Financial Instruments

1.1 Introduction

Chapter 2: Equities

2.1 Listed and Unlisted Equities

2.2 Multi-Listed Securities

2.3 The Issuance of Listed Equities – The Primary Market

2.4 The Secondary Market in Equities

Chapter 3: Debt Instruments

3.1 Types of Debt Instruments

3.2 Accrued Interest on Bonds in the Secondary Market

3.3 More Trade Terminology

3.4 How Prices are Formed in the Secondary Market

Chapter 4: Cash

4.1 Cash as A Means of Exchange

4.2 Cash as An Investment Class

4.3 More Trade Terminology

Chapter 5: Derivatives

5.1 Exchange Traded Derivative Contracts

5.2 More Trade Terminology

5.3 OTC Derivatives

Chapter 6: Common Attributes of Financial Instruments

6.1 Summary of All Trade Terminology Used in Chapters 1 to 5

6.2 Summary of Basic Trade Arithmetic for Transactions in Securities, Futures and Options

Chapter 7: Market Participants

7.1 Introduction

7.2 Investors

7.3 Institutional Fund Managers

7.4 Private Client Stockbrokers and Investment Managers

7.5 Investment Banks that Accept and Execute Orders from Investors

7.6 Investment Exchanges

7.7 Settlement Agents

7.8 Other Market Participants

Chapter 8: How Investment Firms are Regulated

8.1 Introduction

8.2 Objectives of Regulation

8.3 The Global Perspective

8.4 The European Perspective

8.5 The UK Perspective – The Role of the Financial Services Authority

8.6 Specific Offences in the United Kingdom

8.7 Regulation and Its Impact on the IT Function

Chapter 9: Straight-Through-Processing

9.1 Introduction

9.2 To What Extent is STP Actually Achieved in Practice?

Chapter 10: The Role of Accurate Static Data in the STP Process

10.1 Static Data Overview

10.2 Duplication of Static Data Across Systems

10.3 Instrument Group Static Data

10.4 Instrument Static Data

10.5 Trading Party and Settlement Agent Static Data

10.6 Standard Settlement Instructions (SSIs)

10.7 Static Data that is Internal to the Firm Concerned

10.8 Normal Working Days and Public Holidays

10.9 Country Information

Chapter 11: Communications Between Industry Participants

11.1 SWIFT

11.2 The Financial Information Exchange (Fix Protocol)

11.3 Other Message Standards

Chapter 12: The Trade Agreement and Settlement Processes

12.1 The Trade Agreement Process

12.2 Communications Between the Trade Party and Its Settlement Agent

Chapter 13: Failed Trades – Causes, Consequences and Resolution

13.1 Failed Trades – Causes

13.2 Consequences of Failed Trades

13.3 The Prevention and Resolution of Failed Trades and the Impact on it Applications

Chapter 14: An Overview of Investment Accounting

14.1 Role of the Financial Control Department

14.2 Departmental Systems

14.3 The General Ledger

Chapter 15: The Stock Record – Using the Double-entry Convention to Control Positions and Security Quantities

Chapter 16: Example STP Flows of Equity Agency Trades – When Execution Venue is the London Stock Exchange

16.1 Introduction

16.2 Equity Agency Trades with Institutional Investor Customers

16.3 Equity Agency Trades with Private Investor Customers

16.4 Direct Market Access

Chapter 17: The STP Flow of Debt Instrument Trades

17.1 Introduction

17.2 Order Placement

17.3 Order Execution

17.4 Trade Amounts

17.5 Trade Agreement

17.6 Regulatory Trade Reporting

17.7 Settlement

17.8 General Ledger Postings for the Trade and the Settlement

17.9 Stock Record Postings for the Trade and the Settlement

17.10 Position-Related Events

Chapter 18: The STP Flow of Foreign Exchange and Money Market Trades

18.1 Foreign Exchange

18.2 Money Market

Chapter 19: The STP Flow of Futures and Options Transactions

19.1 Introduction

19.2 Futures and Options – Common Process Steps

19.3 Futures-Specific Process Steps

19.4 Options-Specific Process Steps

Chapter 20: The STP Flow of Swap and other OTC Drivative Trades

20.1 Introduction

20.2 Order Placement

20.3 Order Execution

20.4 Trade Components and Amounts

20.5 Trade Agreement

20.6 Regulatory Trade Reporting

20.7 Settlement

20.8 General Ledger Postings

20.9 Stock Record Postings

20.10 Marking to Market

20.11 Daily Accrual of Interest

Chapter 21: Stock Lending, Repos and Funding

21.1 Introduction

21.2 Stock Lending and Borrowing Transactions

21.3 Repo Transactions

21.4 Summary of the Differences Between the Various Transaction Types

21.5 The Role of Specialist Lending Intermediaries (SLIs)

21.6 Business Applications to Support Stock Lending and Repos

Chapter 22: The Impact of Islamic Finance

22.1 Introduction

22.2 Delivering Islamic Financial Services

22.3 Sharia Compliant Instruments

22.4 The Valuation and Risk Management of Islamic Financing Instruments

22.5 The IT Implications of Providing Islamic Instruments

Chapter 23: The Management of Positions

23.1 Introduction

23.2 Trade Dated, Value Dated, Settled and Depot Positions

23.3 Interest Payments and Interest Rate Fixings

23.4 Collection of Maturity Proceeds

23.5 Dividend Payments

23.6 Corporate Actions

23.7 Listed Derivatives – Contract Expiry and Delivery Dates

23.8 Marking Positions to Market

23.9 Accrual of Interest

23.10 Other Accruals

23.11 Reconciliation

Chapter 24: The Management of Risk

24.1 Forms of Market Risk

24.2 Forms of Credit Risk

24.3 Other Forms of Risk

24.4 The Role of the Board of Directors in Managing Risk

24.5 The Role of the Risk Management Department

24.6 An Introduction to Value-At-Risk (VaR)

Part Two: Good IT Practice in the Investment Industry

Chapter 25: The Role of the IT Department in Daily Operations

25.1 Introduction

25.2 User Support and Helpdesk Management

25.3 Data Security, Data Retention, Data Protection and Intellectual Property

25.4 Change Management

25.5 Business Continuity Planning

25.6 Use of the IT Infrastructure Library in Managing it Operations

Chapter 26: The Role of the IT Department in Managing Business Change

26.1 Introduction

26.2 The Software Development Lifecycle

26.3 Project Management Standards

26.4 Software Development Models

26.5 Requirements Gathering

26.6 Quality Assurance Testing

Chapter 27: Package and Vendor Selection, Outsourcing and Offshoring

27.1 Making the Buy or Build Decision

27.2 Vendor and Package Selection

27.3 Outsourcing and Offshoring

Appendix 1: Bond Market Price Calculations

Straight Bond Calculations

FRN Calculations

Valuation Methodologies for Other Types of Debt Instrument

Appendix 2: Summary of Contractual Documents

Further Reading

Glossary of Terms

Index

The Investment Industry for IT Practitioners

The Securities & Investment Institute

Mission Statement:

To set standards of professional excellence and integrity for the investment and securities industry, providing qualifications and promoting the highest level of competence to our members, other individuals and firms.

The Securities and Investment Institute is the UK’s leading professional and membership body for practitioners in the securities and investment industry, with more than 21000 members with an increasing number working outside the UK. It is also the major examining body for the industry, with a full range of qualifications aimed at people entering and working in it. More than 40000 examinations are taken annually in more than 30 countries.

You can contact us through our website www.sii.org.uk

Our membership believes that keeping up to date is central to professional development. We are delighted to endorse the Wiley/SII publishing partnership and recommend this series of books to our members and all those who work in the industry.

As part of the SII CPD Scheme, reading relevant financial publications earns members of the Securities & Investment Institute the appropriate number of CPD hours under the Self-Directed learning category. For further information, please visitwww.sii.org.uk/cpdscheme

Ruth MartinManaging Director

Copyright © 2008 Andrew Bradford

Published byJohn Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex PO19 8SQ, England

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Library of Congress Cataloging-in-Publication Data

Bradford, Andrew. The investment industry for IT practitioners: an introductory guide / Andrew Bradford. p. cm. – (Financial services operations) Includes bibliographical references and index. ISBN 978-0-470-99780-2 (cloth) 1. Financial services industry–Information technology. 2. Investments–Data processing. 3. Investment analysis–Data processing. 4. Business–Data processing. 5. Information technology–Management. I. Title. II. Title: Guide to the investment industry for IT practitioners. HG173.B673 2008 332.6–dc22

2008031719

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

ISBN 978-0-470-99780-2 (HB)

To Marilyn, Victoria and Charlotte

Introduction

A high proportion of information technology graduates find themselves working for investment firms such as investment banks, fund managers, custodians and wealth managers. In their new jobs they very often feel overwhelmed by the complexity of what it is that their new employers are trying to do; the jargon that is used and the complexity of the application configurations that are involved in processing the transactions.

This book is aimed at information technologists who are employed in the investment industry in roles such as developers, business analysts and quality assurance analysts.

The book fulfils two functions. Part One provides the reader with an understanding of the financial instruments and transactions that their employer is concerned with. It introduces the concept of straight-through-processing (STP), explains the lifecycle of the common transactions in the relevant instruments and also deals with the events and actions that are the consequences of holding positions in the instruments concerned. It does not deal in detail with the valuation and analytical tools that are required to value and price complex instruments and transactions, as these topics are well covered by a number of other publications.

The instruments and transaction types that are included in the book’s scope are equities, debt instruments (including fixed rate bonds and floating rate notes), currencies (including money market loans and deposits and foreign exchange), listed futures and options, OTC derivatives such as swaps and hybrid transactions (including stock lending and repo transactions).

Because many financial institutions – including those with little or no historical connection with Islamic countries – now trade Sharia compliant products such as Sukuks, the book also provides an introduction to these instruments.

This book also explains how investment firms are regulated and the impact of financial regulation on the business applications that are used to process transactions and manage positions; as well as outlining the financial accounting requirements of investment firms.

As each of the above topics is explained, the book goes on to examine the necessary content of the business applications. It explains what static data these applications need to hold and why; what messages they need to send and receive and why; and what accounting entries they need to pass for both cash and stock for each of the instruments within the book’s scope.

There are many different kinds of “players” in the financial markets, including investment banks, institutional fund managers, private client fund managers and stockbrokers, money brokers, custodians and investment exchanges to name but a few. The IT infrastructures of each type of market player are different. This book is written from the perspective of a bank or broker that processes trades in and holds positions in all the instruments and transaction types that are within the book’s scope.

Chapter by Chapter, Part One is structured as follows.

Chapters 1 to 5 introduce the reader to five classes of financial instrument that are used as investments – equities, debt instruments, cash, listed derivatives and OTC derivatives. It explains the basic characteristics of each instrument, and introduces the reader to the basic calculations involved in trades in these instruments. Chapter 6 then summarises the common elements of all these different instruments.

Chapter 7 describes the roles of the various types of companies that operate in the investment industry, including investment banks, fund managers, hedge funds, investment exchanges, clearing houses, custodians, central securities depositaries and private client stockbrokers, and examines how these firms interact with each other when the various financial instruments are bought or sold, or borrowed and lent.

Chapter 8 describes how investment firms are regulated, with particular emphasis on the UK and the European Economic Area.

Chapter 9 introduces the reader to the concept of straight-through-processing, and Chapter 10 examines the importance of accurate static data to achieve this goal.

Chapter 11 examines how messages are exchanged between the different types of market practitioners in the process of placing orders, executing them, agreeing that the resulting trades are correct and then settling the trades. This chapter covers all the instruments described in Chapters 1 to 6. It also describes the role of SWIFT and the FIX Protocol in standardising and carrying messages between different companies that are active in investment.

Chapter 12 describes the processes of trade agreement and the contents of settlement instruction messages for all the instruments that were covered in Chapters 1 to 5; and Chapter 13 examines the consequences of failed or late settlement of transactions.

Chapter 14 examines the concepts involved in investment accounting and book-keeping, both for cash amounts and the business content requirements of the general ledger applications; while Chapter 15 examines the function and business content of the stock record application, which fulfils the same function for security quantity book-keeping.

Chapters 16 to 20 provide example STP flows from the order being placed through to the trade being executed, confirmed and settled for each of the instruments that were described in Chapters 1 to 5.

Chapter 21 examines securities lending and borrowing and repo transactions and the business content requirements of applications that are used to process these transactions.

Chapter 22 examines the impact of the growing market for financial instruments that meet the requirements of Sharia law, and how these Sharia compliant instruments and transactions differ from the standard instruments and transactions that were described in earlier chapters.

Chapter 23 examines the activities involved in and the business application content requirements for the management of an investment portfolio, including dividend, coupon and corporate actions processing, marking to market, accrual of interest and reconciliation.

Chapter 24 outlines how risk is measured and managed in an investment firm and the business applications that are involved in the process.

Part Two of the book looks at the role of the information technology department of the investment firm. The activities covered in Part Two are common to all types of organisations, not just investment industry firms.

Chapter 25 examines how the IT department manages day-to-day activities such as application support, helpdesk management, data retention requirements, change control procedures and business continuity planning.

Chapter 26 examines how the department manages change. It looks at software development lifecycles, project management standards, requirement gathering techniques and application testing strategies and techniques.

Chapter 27 examines the processes of software vendor and package selection, and outsourcing and offshoring of activities.

HOW TO USE THIS BOOK

I have attempted to gradually build up the reader’s knowledge of instruments, transactions and events within transactions as the book progresses. As a consequence, the later chapters of Part One often make reference to points covered in earlier chapters, and there are also forward references within the earlier chapters. I therefore recommend reading the book chapter by chapter, rather than reading individual chapters in isolation.

Words and terms that are included in the Glossary of Terms are highlighted in bold the first time that they appear in the text.

I have made every effort to avoid errors in the text, but any that remain are my responsibility and I apologise for them. I would welcome opportunities to correct errors in any future editions, and would appreciate being informed of them by email to [email protected].

Acknowledgements

I would like to thank the following individuals who have assisted with this book:

Andy Mead of National Grid plc Ashley Rayfield of Cable and Wireless plc David Flinders and Marcus Dutton of City Networks Limited John Silver of Atlassian Software Systems Pty Limited Kim Arnold and Christian Galligher of Omgeo llc Jenny McCall, Viv Wickham and Hana Bellova of John Wiley, and Elaine Andrews for her helpful comments on the first draft of this book.

Part One

Investments and Securities Explained

Chapter 1

An Introduction to Financial Instruments

1.1 INTRODUCTION

The investment industry exists to serve its customers. There are two main groups of customers – investors and security issuers. Investors may be private individuals, charities, companies, banks, collective investment schemes such as pension funds and insurance funds, central and local governments or “supranational institutions” such as the World Bank.

Investors in turn have investment objectives, which may be to increase wealth (capital growth) or to provide income. Some investors will have only one of these objectives, some will have both. For example, a high earning private individual probably has all the income that he or she needs from employment, and wishes to invest surplus cash to provide capital growth. A charity, however, may need the maximum possible income that it can get from its investments in order to fund its activities.

There are four main classes of financial instrument that investors make use of to achieve either income or capital growth. These are:

Equities, also known as stocks or sharesDebt instruments, also known as bonds or billsCashDerivatives.

Equities and debt instruments are collectively known as securities. In order for there to be any securities for the investor to invest in, then some organisation, such as a company, a bank, a government or a supranational institution, has to issue securities. Securities issuers are the other main customer group, and the reason that securities are issued is to provide capital for a business or (if the issuer of the security is a government) to fund government expenditure.

The next four chapters provide the basic details of each instrument type, and Chapter 6 summarises the features that are common to them all.

Chapter 2

Equities

Companies issue equities to provide them with a permanent stock of capital to fund their business activities. The investors in that company are known as shareholders, as each investor holds a share in the ownership of the business. The investor expects to be rewarded in two ways. If the company does well then the market value of each share will increase over time, providing the investor with capital growth. In addition, the investor expects that the company will also provide a source of income in the form of regular dividends. Dividends are a way of distributing the profits of the company to its shareholders.

There are no guarantees that the investor will in fact benefit from either capital growth or from dividend income. For example, a young company with an exciting new product which it is bringing to market for the first time may not have any income to distribute yet, but because other investors take a very positive view of its long-term prospects, there may be considerable scope for capital growth. At the other end of the spectrum, an old established company that produces low technology products that do not require lots of investment may have a high income, but very limited prospects for capital growth.

Case study: Amazon.com

Amazon.com was founded in 1994 and issued its shares to the public for the first time in 1997, at US$18.00 per share. It made losses until 2002 when it produced a profit of US$5 million, just 1¢ per share, on revenues of over US$1 billion. In 2006 it made a profit of US$190 million, but it has never distributed any profits to investors in the form of dividends. However, as a result of three stock splits1 in 1999 each investor who purchased one share now owns 12 shares, which at the time of writing in 2007 were trading at US$82.70 each. This means that the original investment of US$18 is now worth US$992, and there has been capital growth of US$974 over 10 years.

A third possibility is that a company continues to make either very low profits or actual losses and investors take a negative view of its long-term prospects. In such a case income distribution in the form of dividends is likely to be very low or non-existent, and the prospects for capital growth are negative. In other words the investors are more likely to lose capital than to increase it.

2.1 LISTED AND UNLISTED EQUITIES

In this book we are concerned with equities that are regularly bought and sold by professional investment firms. Usually, such equities are listed on one or more stock exchanges. However, not all equities are listed on a stock exchange. Private companies are often owned by their founding families and do not have stock exchange listing. Companies that do have their shares listed are known as public companies; and most medium-sized public companies list their shares on a single stock exchange in the country in which they are incorporated.

2.2 MULTI-LISTED SECURITIES

Many large multinational companies, however, list their shares on a number of exchanges in different countries. For example, Sony Corporation shares are listed on the Tokyo Stock Exchange (where Sony shares are priced in Japanese yen), the London Stock Exchange (where prices are quoted both in yen and sterling); the New York Stock Exchange (prices quoted in US dollars); and on the Deutsche Borse (prices quoted in euros).

2.3 THE ISSUANCE OF LISTED EQUITIES – THE PRIMARY MARKET

When a company that was previously privately owned lists its shares on a stock exchange, it will almost invariably look to issue additional new shares in order to raise extra capital at the same time. The money paid by investors for the newly issued shares goes directly to the company. The sale of shares by the company for the first time is known as the primary market for that company’s shares. It is also known as an initial public offering (IPO), or just public offering, of those shares.

The IPO introduces the company to a wide pool of stock market investors to provide it with capital for future growth. The existing shareholders will see their shareholdings diluted as a proportion of the company’s shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms.

In addition, once a company is listed, it will be able to issue further shares to the new and existing shareholders via rights issues. Rights issues enable existing shareholders to buy further stock at a discounted price, and also provide the issuer with further capital for expansion. This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list their shares.

IPOs generally involve one or more investment banks as “underwriters”. The company offering its shares, called the “issuer”, enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell them these new shares.

2.4 THE SECONDARY MARKET IN EQUITIES

Equity capital is permanent; the issuer does not as a rule return it to the investor2 and therefore there has to be a means by which the investor can realise its capital gain, or sell its holding to prevent further losses. For this reason, stock exchanges provide a marketplace for investors to buy and sell shares in the companies in which they are interested. This marketplace is known as the secondary market, to distinguish it from the initial distribution of shares by the company, which is known as the primary market. The role of investment exchanges is discussed more fully in Chapter 7.

When shares are bought and sold on the secondary market, each purchase and sale is known as a trade. When one investor (the seller) sells all or part of a holding to another investor (the buyer), then:

1. The buyer needs to pay the sale proceeds to the seller

2. The seller needs to deliver the equities to the buyer.

The process of organising the exchange of stock and cash is known as trade settlement. Settlement can occur on the same day that the trade was done, but more usually occurs a few days after the date of the trade. In most securities markets, settlement normally takes place three business days after the trade date.

2.4.1 Trade prices in the secondary market

The price at which equities are bought and sold in the secondary market depends upon supply and demand, and prices of an individual company’s shares fluctuate according to market participants’ views as to the prospects of:

Individual companiesIndustry sectors in which these companies operateThe economies of the countries in which they operateThe perceived probability of another company paying a premium to acquire this company.

2.4.2 Secondary market terminology

When equities are traded on the secondary market there are a number of terms used to describe the features of that trade. Table 2.1 examines some of these terms before proceeding – others will be introduced later in the book.

Table 2.1 Equity trade terminology

TermExplanationBid priceThis is the price that a professional dealer is prepared to buy a given quantity of the security concerned from an investorCommissionThe amount that an agent will charge the investor for executing the tradeConsiderationPrincipal value + Commission + FeesFeesAny other charges levied on this trade other than commissionMid priceThe average of bid price and offer priceNominal amountThe quantity of securities being purchased or soldOffer priceThis is the price that a professional dealer is prepared to sell a given quantity of the security concerned to an investorPrincipal valueNominal amount * The price of the tradeSettlementThe process where the buyer pays the proceeds of the trade and receives legal title to the item it has purchased; while the seller receives the proceeds of the trade and has to deliver the item it has sold to the buyerTradeWhen one investor sells some or all of its holding in a financial instrument, or another investor buys a holding in a financial instrument, then the resulting transaction between the two investors is known as a trade. The terms deal and bargain are also often used to describe this activityTrade dateThe date that the two parties agreed to carry out the tradeTrade priceThe price of this particular tradeValue dateThe date that the seller will deliver the securities to the buyer and the buyer will pay the consideration to the seller. Also the date that the legal ownership of the securities changes from the buyer to the seller

On most exchanges, equity prices are quoted as units of currency, e.g. US$10.00 per share. The notable exception to this rule is the London Stock Exchange, where equity prices are more often quoted in pennies than in whole pound units.

2.4.3 Forms of securities

Securities (both equities and debt instruments in this context) may be issued in one of the following forms:

Registered securities are where the name and address of the owner are recorded on a register maintained by a firm is known in some countries as a registrar and in others as a transfer agent. The register contains the holder’s name, address, quantity of shares or bonds owned, and the dates on which they were acquired. Registered shares may, in turn, exist in one or other of the following forms:

– Certificated form – the evidence of ownership is represented by a share certificate which is printed and sent to the holder shortly after purchase. If the holder wishes to sell some or all of its holding, then it has to deliver the certificates as part of the settlement process.

– Dematerialised form – no certificates are issued, the share register itself is the evidence of ownership.

Bearer securities are issued where there is no register or registrar. When the security is first issued on the primary market, the issuer prints certificates representing the entire amount of shares or bonds issued, and these are posted to the investors who have purchased the shares in the primary market. If an investor wishes to sell all or part of its holding then it has to deliver the bearer certificates as part of the settlement process.

Prior to 1990, most securities were issued in either registered certificated form, or in bearer form. However, as securities trading became more global, the need to move large amounts of physical paper around the world whenever bonds or equities were traded in the secondary market became a major obstacle to efficient settlement. Financial regulators encouraged issuers to issue securities in dematerialised form, and investment exchanges set up the necessary market infrastructure to handle the trading and settlement of dematerialised securities.

1 A stock split is a form of corporate action where the total number of shares in issue is increased, and the additional shares are given to existing shareholders in proportion to their existing shareholding free of cost.

2 There are exceptions to this rule; some companies that have surplus capital do engage in share buyback programmes.

Chapter 3

Debt Instruments

Companies, banks, central governments (such as the United Kingdom, Republic of France, etc.); local governments (such as the city of Manchester, province of Quebec, State of California, etc.) and supranational institutions (such as the World Bank, European Union, etc.) also raise cash by issuing debt instruments, also known as bonds and bills.

A debt instrument is effectively an “IOU” – a promise to pay the investor periodic amounts of interest (known as the coupon) on a loan and also the promise to return the amount borrowed to the investor at a date in the future. Unlike equities, debt instruments are usually (but not exclusively) issued for a defined period of time, after which they are said to mature. Upon maturity date the amount borrowed is returned to the investors together with the final coupon payment. As with equities, debt instruments are traded on a secondary market so that investors may buy and sell them without the involvement of the issuer.

The main differences between debt and equity finance are as follows:

Only companies can issue equity shares, as companies can be owned by others. Central and local governments belong to society as a whole; by definition they cannot be owned by others, so when governments need to raise capital they have to use the debt markets.Debt instruments provide a predictable, guaranteed form of income – the interest on the bond – which is known as the coupon. The coupon is paid at regular intervals at a guaranteed rate of return; unlike dividends which are dependent upon the fortunes of the company that issued the shares. For this reason, debt instruments are also known as fixed income securities.Debt instruments provide very restricted opportunities for capital growth compared with equities.

Like listed equities, bonds are issued on the primary market and may be bought and sold by investors in the secondary market. They are sometimes listed on stock exchanges, but more often they are traded by investment banks outside of the stock exchange, on what is known at the over-the-counter market, or OTC market. An investor that wishes to buy or sell a particular bond contacts a number of investment banks to ask them at what price they are willing to buy or sell a given quantity of a given bond. As with equities, secondary market bond prices vary according to supply and demand, and the factors that affect those prices are discussed in section 3.4.

3.1 TYPES OF DEBT INSTRUMENTS

3.1.1 Straight bonds

Straight bonds, also known as “plain vanilla” bonds, are the simplest type of debt instrument, because the amount of the coupon to be paid by the borrower is fixed for the entire life of the bond. Consider the following example: