eFinanceManagement | Financial Management Concepts in Layman's Language

Exotic Options

An exotic option is an over the counter (OTC) option which is more complex than commonly traded plain vanilla options in terms of the option behaviour with respect to the underlying, computation and timing of the pay-out, and the terms of the customised contract. Exotic options are generally used in foreign exchange market, fixed income market and high stakes over the counter equity and index trading markets. Since they are difficult to understand and are highly customised, they are not allowed to be traded on exchanges. Many businesses use these options to hedge their cash flow uncertainties and enter into over the counter contracts with large financial institutions which can structure and price such products.

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Strategic Alliance

What is Strategic Alliance (Definition):

It is an agreement between two entities to pool their resources for achieving a common business goal. Strategic alliances (SA) are generally entered when each entity to the agreement possess some kind of an expertise. This expertise, when combined makes them complete and provides a distinct competitive advantage to both the entities. Unlike Joint Venture, SA doesn’t necessitate the creation of the new entity. As a result, the entities involved in SA can continue to operate as an independent entity.

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Joint Venture

What is a Joint Venture

Joint Venture (JV) is an agreement between two or more parties to combine their resources (generally: capital, know-how, execution capability, local network) in achieving the common business goal. Unlike most partnership arrangements, Joint Ventures are for a limited duration and specific purpose.

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Asset Backed Securities

Asset backed securities (ABS) are debt instruments collateralised by a variety of loans and obligations. These obligations usually include student loans, credit card receivables, auto loans, home equity loans etc. The obligations of different investment ratings are pooled together and then sold off to investors by breaking them up into smaller units through a process known as securitisation.

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Convertible Bonds

A convertible bond is a type of debt instrument which also has equity-like features. It can be converted into the shares of the issuing company at a later date and at a pre-determined conversion price. It can also be classified as a derivative instrument because it derives its value from both the prevailing interest rates and the stock price of the company. Convertible bonds are usually issued by those companies which have a lower credit rating. Because of the lower rating, they would need to pay a high coupon rate and a high yield to attract investors to their bonds. So instead of issuing plain bonds, they issue convertible bonds. Convertible bonds have a lower yield than the plain bonds, but provide additional upside to the investors through conversion to equity. If the investors are not able to convert their bonds, they will anyways be entitled to the regular coupon payments, albeit at a rate lower than the market. It is a win-win for both the issuer and the investor. Convertible bonds are also termed as just ‘convertibles’ or ‘converts’.

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Callable Bonds

A normal bond can be issued with embedded options. One such bond is a callable bond. A callable bond is like a normal bond but with an embedded call option which gives the issuer a right to recall the bond before its actual maturity is over. So, basically, a callable bond has two lives – one is its normal maturity and the other is when it is called by the issuer. Since a callable bond gives additional benefit to an issuer, he has to pay a premium to get this benefit. That’s why a callable bond has a higher coupon rate than a normal bond. In addition, the issuer may pay a premium to the bond’s par value if it is called before maturity. All these conditions are explicitly mentioned in the bond indenture beforehand.

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Bonus Share

Bonus shares are the additional shares given to the current shareholders of the company free of cost, in proportion to their existing shareholding. Such an event is called a Bonus Issue. Bonus shares are given to the current shareholders in lieu of a dividend pay-out. So, these are also called Stock Dividend.  Instead of paying out a cash dividend, the company converts a part of its reserves to equity capital and issues additional shares. The company preserves its cash while still satisfying the shareholders’ desire for a dividend. A bonus issue increases the number of outstanding shares of the company, but the market value remains the same. So, there is a drop in the share price of the company because of bonus issue. The existing shareholders don’t face any dilution in their stake due to a bonus issue. The class of shareholders to which the company issues the bonus shares is decided as per the company incorporation documents.

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Options

An option is a derivative instrument which derives its value from another underlying asset. An option holder or buyer has a right to buy or sell the underlying asset from or to, respectively, an option writer or option seller at a pre-determined price. The event when such a transaction happens is called exercising the option. Depending on the type, an option can be exercised during or at the end of its exercise period or life. One key aspect of an option is that it’s a “right” and not an “obligation”, which means the option holder can decide to exercise the option or let it expire worthless at his will. On the other hand, it is an obligation for the option writer to sell or buy the asset at the pre-determined price when the option holder chooses to buy or sell, respectively.

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Warrants

A warrant is a derivative instrument which gives the warrant holder a right to buy the underlying stock at a pre-determined strike price. A warrant holder can exercise the warrant to buy the stock of the issuing company at an attractive price at a later date. It is basically a discount to the market price of the company’s stock. Warrants are issued by the companies along with a debt or preferred stock issue. It makes the yield attractive for potential debt investors. Warrants are usually traded OTC. Financial institutions also issue warrants where the underlying assets can be currencies, commodities, interest rates etc.

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Import and Export Letter of Credit

A letter of credit is a vital tool for facilitating international trade. It benefits both the importers and exporters. An import letter of credit enhances the credit worthiness of the importer while an export letter of credit mitigates the credit risk for the exporter and helps improve his cash flow.

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