Indian companies in the international financial markets:

A study on Foreign Currency Convertible Bonds

(Track-F)

Ramesh Chandra Das

Research Scholar

Vinod Gupta School of Management

IIT Kharagpur, West Bengal-721302

E-Mail ID-rameshchandradas99@gmail.com

Dr.Chandra Sekhar Mishra

Assistant Professor

Vinod Gupta School of Management

IIT Kharagpur, West Bengal-721302

E-Mail ID-csmishra@vgsom.iitkgp.ernet.in

Prof.Prabina Rajib

Professor

Vinod Gupta School of Management

IIT Kharagpur, West Bengal-721302

E-Mail ID- prabina@vgsom.iitkgp.ernet.in

1
 Indian companies in the international financial markets:

A study on Foreign Currency Convertible Bonds

Abstract: Foreign currency convertible bonds have been the important sources of financing
for mid-cap industries in India. But due to Macro economics factors like falling of stock
market and currency fluctuation it has created a negative impact for the this sectors. Here this
paper attempts to develop a valuation model based on partial least squares regression, by
using data from BSE stock market. In the second cases, it tries to analyze the announcement
effects of offerings of foreign currency convertible bonds using data from BSE stock market.

Keywords: International financial market; Foreign currency convertible bonds

1. Introduction:

The growth of any developed country depends upon efficient and well regulated capital
market. During the last decade, unprecedented developments in the global financial markets
and the reduction of boundaries have led to formulation of unified and integrated global
financial market. This has provided the potential investors and borrowers with Varity of
options for lending and raising funds to and from any corner of the world.

The Indian capital market is emerging as one of the ‘best regulated’ and ‘transitionary’
markets across the world .It unveils an efficient ‘trading and settlement ‘system, high levels
of disclosers and environment of innovation. All has further given a push to the birth of
various new avenues of raising funds that were earlier non-existent in the capital market. For
examples American depository receipts (ADR), Global depository receipts (GDR), External
commercial borrowings (EDR) and foreign currency convertible bonds (FCCB).As per the
times news network India alone accounts for 65% of FCCB issued in the Asia-Pacific market.

2
1.1. Conceptual Framework of FCCB:

It is a bond issued by the corporations in a currency other than the home currency containing
twin features of equity and debt. Otherwise it is called a hybrid security which is embedded
with the derivatives. It has two components like ‘debt’ as well as ‘equity’. The component
consisting of debt represents the liability of the company for future interest coupon payments
and redemption amount. The ‘equity ‘component represents the value of the ‘option’ that the
bond holders have to convert into ordinary shares of the company.

As per Investopedia1 FCCB are, “a type of convertible bond issued in a currency different
than the issuer’s domestic currency or the money being raised by the issuing company in the
form of a foreign currency. A convertible bond is a blend of a debt and equity instrument. It
is like a bond for making regular coupon and principal payments, but also giving the
bondholder the option to convert the bond into stock.”

In Indian context, Foreign Exchange Management Act, 1999 (FEMA) describes FCCB as, “a
bond issued by an Indian company expressed in foreign currency and the principle and
interest in respect of which is payable in foreign currency.” However, FEMA omits the
element of convertibility in the above definition.

On the other hand, issue of FCCB through Depository Receipt Mechanism Scheme, 1993 is
free from this defect and defines FCCBs as, “FCCBs are the bonds issued in accordance with
the scheme and subscribed by a non resident in foreign currency and convertible into ordinary
shares of the issuing company in any manner, either in whole or in part, on the basis of any
equity related warrants attached to debt instruments.”

During the recent global economic crisis the credit and liquidity ratings of many countries,
sectors, companies, and bonds has been put to question. The Indian FCCB universe have
been adversely impacted with many scaremongering stories making it appear that all such
FCCBs are under threat – in particular under threat of non-redemption by companies – quite
simply meaning default. In addition, I do believe since the market for FCCBs is very illiquid
there has been an occurrence of severe miss-pricing.

3
As a result many investors are unsure as to the

1. Credit worthiness of companies with such FCCBs

2. True valuation and pricing of FCCBs

3. The likeliness or unlikeliness of companies that can redeem or refinance to redeem.

1.2. Significance:

In the current scenario foreign currency convertible bonds have turned the inevitable
problems for most of the sectors like steel, software, pharmaceutical, Education, healthcare,
consumable goods, petroleum sector etc.Irrespective of healthy financial statement, corporate
sectors are unable to repay their debt. Even none of the investors are interested to invest of
those particular sectors. For which share price has reduced and companies have unabled to
raise money from the capital market.

2. Literature review:

Eugene F.Brigham (1966) has discussed the theoretical framework for analyzing the nature of
convertible securities. The major findings of the study that convertible bond has a market
value floor which is set by the higher of its conversion value.

Werner G.Frank and Jerry Jo Weygandt(1971) have suggested that the Accounting policy
Board’s(APB)criterion may be inferior to the use of a convertible debentures conversion
value/call price ratio as an indicator of a future dilution of earnings per share.

Dan Givoly and Dan Pamon (1981) have shown of their study that the reliance on the date of
issuance might lead to a somewhat meaningless classification bonds as common stock
equivalent (CSE), regardless of which method is used.

J. Ronald Hoffmeister (1987) has found that corporations do follow timing strategies when
issuing convertible bonds. The number of convertible bond offerings increases and decreases
as conditions changes in the economy and capital market.

4
Thomas s.y HO and David (1996) have stated that convertible bond is fully sensitivity to the
stock price, means if the stock is overvalued then the CB will be overvalued, likewise if the
stock price will be undervalued the CB price will be undervalued

Manzur Rahman, and Shreesh Deshpande (1997) have noted that on average, the valuation
effects for Multinational corporations and Domestic corporations are largely similar.

Mayer’s, D., (1998) Predicts that investment and financing activity will increase following
the convertible bond calls.

Frans de Roon and chirs Veld (1998) have analysed a positive but insignificant effect on
stock prices for the announcement of a CB and a significant positive effect for the
announcement of a WB.

Inmoo Lee and Tim Loughran (1998) have found that long run convertible bonds issuing
firms significantly underperform similarly sized firms.

Yong O. Kim and Jarl Kallberg (1998) have defined that there exists a threshold attribute

such that those with unfavourable information ( <θ) will force conversion, while others (θ>

) will not. Likewise all have shown that a threshold attribute is smaller with convertible debt
than with convertible preferred stock ( p).

Abhay Abhyankar and Alison Dunning (1999) have shown analysing the issue of securities
(convertible bond, convertible capital bond, convertible preferred shares) negative impact of
firm value. The reaction of convertible bonds is similar to that for convertible preference
shares.

Nobuyuki Isagawa (2000) has shown that callable convertible debt is an effective financial
instrument for controlling a self interested manager.

5
Radu Burlacu (2000) has analysed that announcement effects at French CB issues by
controlling for the debt and equity components and revealed that, on average, a higher equity
component implies a more negative market response.

Craig M.Lewis, Richard J.Roglski, James K.Seward (2002) has found that convertible debt
offers convey information about the issuer’s systematic and unsystematic risk. And also
defined that systematic asset and equity risk declines for issuer’s systematic and unsystematic
risk.

Manuel Ammann,Axel Kind,Christian wilde(2003) proved the positive relationship between

under pricing and maturity. Also shown that it can be decreased by moneyness further in- the
money.

Craig M.Lewis, Richard J.Rogalski (2003) has found that convertible issue is interrelated
with the firm value, financial leverage, investment opportunities, and the rate of future
growth.

Shao-Chi Chang, Sheng-Syon Chen, Yichen Liu (2004) has concluded that the
announcements of convertible offerings by focused firms than to those by diversified firms.
And also other insight has drawn that announcement of convertible debt offerings by
Taiwanese firms are on average associated with significantly positive abnormal return.

Ken L.Bechmann(2004) has concluded that convertible hedge desk and possible underwriter
short sell stock at the time of the call as means of hedging the equity risk associated with the
convertible bond. And also has shown a major insight that the pattern in the number of shares
sold short in related to the called convertible bond issue.

Timo P. KorkeamakiT(2005) has found that firms from countries with weak shareholder
protection issue more debt-like convertibles, and that firms from countries with weak creditor
protection issue more equity-like convertibles.

Alderson M J, Betker B L, Stock D R (2006) has remarked that in the case of out of money
convertible calls there is no relation between changes in investment activity and debt issuance
at the firm level.

6
Jo-Ann Suchard(2007) does provide the announcement effects for convertible debt issue in
the capital market and concluded that convertible debt rights issues underwriting costs are
significantly lower than U.S. or U.K.’s public issues of convertible debt.

Mookwon Jung a, Michael J. Sullivan(2008) has supported that managers arrange the terms
of convertible debt issue to take advantage of their asymmetric information of future growth
prospects while considering the trade-off between risk and growth.

Benjamin Kleidt,Dirk Schiereck(2009) has examined that that convertible debt issuers
experience increases in systematic risk during the post-issue period as well as earnings
declines suggest that most reservations investors may have around the time of the issue are
not unfounded.

Cheng-Few Lee,Kin-wai Lee,Gillian Hian-Hong Yeo(2009) have shown that firms in

countries with stronger share holder rights issue convertible debt with higher expectation
probability of conversion. Specifically in countries with stronger share holder rights, firms in
which the controlling share holders have separation of control rights and cash flow right are
more likely to issue convertible debt with lower probability of conversion

Langnan Chen and Hongwei Liu,Steven Li(2009) have investigated that the valuation of CBs
by using PLSR and proposed a new methodology based on the PLSR also has potential for
valuing CBs in other emerging economics.

Kyokoyagi and katsushige Sawaki (2010) have analysed the value of the puttable Reveres
convertible bond (RCB) is higher than the one of the non-puttable RCB.

Rolland Gillet and Hubert de la Bruslerie (2010) have found the negative market reaction,
mostly measuring abnormal returns within a very short window around the announcement CB
issued.

Ruey-Dang Chang (2010) has signified that there is no significant difference of earning effect
during the time of convertible bonds. Likewise also shown that earning are more within
convertible bond as compared to abroad convertible bonds.

7
Eisdorfer and Assaf(2011) have shown that when convertible and straight debt have equal
priority, shareholders can prefer value-decreasing project which result in wealth transfer from
bond holders to share holders and that problem can be solved when the convertible debt is
subordinated.

Agarwal Vikash (2011) has concluded that the return of a buy-and –hedge strategy involving
taking a long position in convertible bond (CB) while hedging risk alone explains a
substantial amount of these funds’ return dynamics.

Emanuele Bajo and Massimiliano Barbi(2012) have pointed that net time value advantage
(NTVA) is more comprehensive explanation of a firm’s call policy and claimed that the
NTVA effectively quantifies the loss deriving from a delayed call.

2.1. Research Gap:

1. How stock price of BSE is affected due to issue of foreign currency convertible bond in
international market?
2. If it had been not treated as contingent liability, what would have been impact on wealth
of the respective sectors?
3. In Indian context, what extent this instrument does support the investors to convert the
instrument into shares.
4. Had it an effective instrument during bulk the issue (2006-2007) to raise finance from
overseas market?
5. Irrespective of currency fluctuations and falling of stock market, how the corporate
sectors have managed their respective debt?
6. Valuation of FCCBs in Indian context.
7. How Delta ratio is used to hedge the risk of convertible debt?

2.2. Objectives:
1. Impact of BSE stock market prices due to issue of foreign currency convertible bonds
in international market.
2. Valuation of Foreign Currency convertible Bonds using data from BSE stock market.
3. Analyse of foreign currency convertible bond’s efficiency as compared to other global
financial instruments.

8
3. Hypothesis development:
H0=Announcement of issued foreign currency convertible bonds have no impact on BSE
stock market.
H1= There is effects of issued foreign currency convertible bonds on BSE stock market.

4. Methodology:
For announcement effects of FCCB, I have selected the standard event study methodology
described by Brown and Warner (1985).It measures excess returns using an ordinary least
square model (OLS) regression.
Ai,t = Ri,t‒ β̂ 0,i‒ β̂1,iRtm

Where Ai,t is the abnormal return for firm i on day t,Ri,t denotes the return on security i on day
t,defined as In(Pi,t) – In(Pi,t-1) and Rtm is the return on the market index.^β0 and ^β1
parameters can be estimated over estimation period by running an OLS regression.
In the second cases valuation of FCCB, I have selected multivariate regression model
originally developed by Wold which has been extensively used in social science. PLSR has
proved useful in explaining a set of dependent variables from a very large set of regressions
with a small number of observations.Therefore; PLSR is suitable for my study, as we have
large number of variables. This can be used one dependent variable or multidependent
variables.

5. Data Collection:
For announcement effects of foreign currency convertible bonds on BSE stock market, I have
selected from January 2005 to December 2011 by BSE listed Indian companies those have
raised money issuing foreign currency convertible bonds from overseas market. In the second
cases for valuation of FCCB, I have selected 150 primary issues which are listed on BSE
stock market.

6. Proposed (Expected) Result:

In my research, the cumulative average abnormal return for an issue of a FCCB may be an
insignificant positive.

9
References:

Bechmann, K. L. (2004). Short sales, price pressure, and the stock price response to
convertible bond calls. Journal of Financial Markets , 7 (4), 427-451.

Benjamin Kleidta, D. S. (2009). Systematicriskchangesaroundconvertibledebt offerings:

Anote on recentevidence. Global Finance Journal , 20 (1), 98–105.

Brown, S.J., Warner, J.B., (1985). Using daily stock returns: The case of event studies.
Journal of Financial Economics, 3-31.

Bruslerie, R. G. (2010). The Consequences of Issuing Convertible Bonds: Dilution and/or

Financial Restructuring? European Financial Management, , 16 (4), 552–584.

Burlacu, R. (2000). New evidence on the pecking order hypothesis: the case of French
convertible bonds. Journal of Multinational Financial Management , 10 (3-4), 439-459.

Craig M. Lewis a, R. J. (2002). Risk changes around convertible debt offerings. Journal of
Corporate Finance , 8 (1), 67–80.

Deshpande, M. R. (1997). Convertible bond calls by multinational and domestic firms: an

agency cost perspective. Journal of Multinational Financial Management , 7 (1), 43-54 .

Dunning, A. A. (1999). Wealth effects of convertible bond and convertible preference share
issues: An empirical analysis of the UK market. Journal of Banking & Finance , 23 (7),
1043-1065.

Eisdorfer, A. (2011). Why is Convertible Debt Subordinated? An Investment‐Based Agency

Theory. The Financial Review , 46 (1), 43-65.

Emanuele Bajo, M. B. (2012). The role of time value in convertible bond call policy. Journal
of Banking and Finance , 36, 550-563.

F.Brigham, E. (1966). An analysis of Convertible Debentures:Theory and some empirical

evidence. Journal of Finance , 2 (1), 35-54.

Frans de Roon a, C. V. (1998). Announcement effects of convertible bond loans versus

warrant-bond loans: An empirical analysis for the Dutch market. Journal of Banking &
Finance , 22, 1481-1506.

Isagawa, N. (2000). Convertible debt: an effective financial instrument to control managerial

opportunism. Review of Financial Economics , 9 (1), 15-26.

J.Ronald Hoffmeister, P. A. (1987). Conditions affecting the timing of convertible bond sales.
Journal of Business Research , 15, 101-106.

10
Kallberg, Y. O. (1998). Convertible calls and corporate taxes under asymmetric information.
Journal of Banking & Finance , 22 (1), 19-40.

Korkeamaki, T. (2005). Effects of law on corporate financing practices--international

evidence from convertible bond issues. Journal of Corporate Finance , 11 (5), 809-831.

Langnan Chen, H. L. (2009). Valuing primary issue convertible bonds: Evidence from China.
Journal of Derivatives & Hedge Funds , 15, 172–185.

Lee C-F, L. K.-W.-H. (2009). Investor protection and convertible debt design. Journal of
Banking & Finance , 33 (6), 985-995.

Lee, C.-L. C.-C. (2010). Convertible Bonds Issuance Terms, Management Forecasts, and
Earnings Management: Evidence from Taiwan Market. Review of Accounting and Finance , 9
(1), 65-87.

Lewis C M, R. R. (2003). Industry conditions, growth opportunities and market reactions to

convertible debt financing decisions. Journal of Banking & Finance , 27 (1), 153-181.

Loughran, I. L. (1998). Performance following convertible bond issuance. Journal of

Corporate Finance , 4 (2), 185-207.

Manuel Ammann, A. K. (2003). Are convertible bonds underpriced?An analysis of the

French market. Journal of Banking & Finance , 27, 635–653.

Mayers, d. (2006). Convertible bonds: matching financial and real options. Journal of applied
corporate finance , 13 (1), 8 - 21.

Mayers, D. (1998). Why firms issue convertible bonds: the matching of financial and real
investment options. Journal of Financial Economics , 47 (1), 83-102.

Palmon, D. G. (1981). Classification of Convertible Debt As Common Stock Equivalents:

Some Empirical Evidence on the Effects of APB Opinion 15. Journal of Accounting
Research , 19 (2), 530-543 .

Pfeffer, T. S. (1996). Convertible Bonds: Model, Value Attribution, and Analytics. Financial
Analysts Journal , 52 (5), 35-44.

Sawaki, y. K. (2010). The valuation of callable-puttable reverse convertible bonds. Asia-

pacific journal of operational research , 27 (2), 189-209.

Shao-Chi Chang, S.-S. C. (2004). Why firms use convertibles: A further test of the
sequential-financing hypothesis. Journal of Banking & Finance , 28 (5), 1163-1183.

Sullivan, M. J. (2009). The signaling effects associated with convertible debt design. Journal
of Business Research , 62 (12), 1358-1363.

11
The impact of rightsissues of convertibledebt in Australianmarkets. (2007). Journal of
Multinational Financial Management , 17 (3), 187–202.

Vikas Agarwal, W. F. (2011). Risk and Return in Convertible Arbitrage: Evidence from the
Convertible Bond Market. Journal of Empirical Finance , 18, 175–194.

Weygandt, W. G. (1971). A Prediction Model for Convertible Debentures. Journal of

accounting research , 9 (1), 116-126 .

Wold, H. (1966) Estimation of principal components and related models by iterative least
squares. In: P.R. Krishnaiaah (ed.) Multivariate Analysis. New York: Academic Press, 391–
420.

12