INNOVATIVE

FINANCIAL
INSTRUMENTS
Presented By:
Akhil Gupta
Anil Dudani
Ankul Baria
Astha Jarora
Atul Handa
Dipen Wahi
Kavish Chouhan

MBA III Sem (Finance)

 1.Interest Rate Cap, Floors and
Collars
 Distinguishing Feature:
 Issuers agrees to make payment to contract purchaser
when:
 Interest Rate exceeds the cap
 Fall below floor/fall outside the collar range
Property:
◦ Seller assumes the risk that interest rate may rise above the
cap (fall below the cap)
 Example:
 An example of a cap would be an agreement to receive a
payment for each month the LIBOR rate exceeds 2.5%.
 2.Interest Rate Reset Notes
Distinguishing Feature:
◦ Interest Rate is reset 3 years after issuance to the greater of
 i. the interest rate
 ii. Rate sufficient to give notes a market value equal to 101% of
their face amount
Properties:
◦ Risk Reallocation/Yield Reduction
◦ Reduced (initial) yield due to reduction in agency cost
◦ Reduction in Agency Cost
◦ Investor is compensated for a deterioration in the issuer’s credit
standing within 3 years of issuance
3.Interest Rate Swaps
Distinguishing Feature:
◦ Two entities agree to swap interest rate payment
obligations, typically fixed rate for floating rate

Properties:
◦ Parties can Benefit the comparative advantages in
different international markets
◦ Usually designed for special opportunities outside
issuer’s market or to circumvent regulations.
 Interest Rate Swap Example

A pays fixed rate to B (A receives variable rate)

B pays variable rate to A (B receives fixed rate).
 4.Medium Term Notes
Distinguishing Feature:
◦ Notes are sold in varying amounts and in varying maturities
on an agency basis.
Properties
◦ Risk Reallocation/Yield Reduction
 Issuer bears market price risk during the marketing
process
◦ Reduction in Transaction Costs
 Agents commissions are lower than underwriting spreads
◦ MTNs offer more flexibility to the issuer and investor both
in terms of structure and documentation.
5. Mortgage Pass-Through
Certificates
Distinguishing Feature:
◦ Investor buys an undivided interest in a pool of
mortgages

Properties:
◦ Risk Reallocation/Yield Reduction
 Reduced yield due to benefit to the investor of
diversification and greater liquidity
◦ Reduction in Transaction Costs
 Most investors cannot achieve the same degree of
diversification as cheaply on their own
6.Negotiable Certificate of Deposit
Distinguishing Feature:
◦ CDs are registered and sold to the public on an agency
basis
Properties:
◦ Risk Reallocation/Yield Reduction
 Issuer bears the market price risk during the
marketing process
◦ More Liquid than non-negotiable CDs
◦ Reduction in Transaction Costs
 Agents’ commission are lower than underwriting
spreads
7. Zero Coupon Convertible Debt
 Distinguishing Feature:
 Non- interest bearing convertible debt issue.

 Properties:
 Tax Arbitrage:
 If issue converts, the issuer will have sold, in effect
Tax deductible equity.
 Other Benefits
 If Holders convert, entire debt service stream is
converted to common equity.
 8. Variable Rate Renewable Notes

 Distinguishing Feature:
 Coupon rates varies monthly and equals a fixed spread over
the one month commercial paper rate.
 Each quarter the maturity automatically extends an additional
quarter unless the investor elects to terminate the extension.
 Properties:
 Risk Reallocation/ Yield Reduction:
 Coupon based on 1 year renewable rates and not on final maturity.
 Reduction in Transaction Costs:
 Lower Transaction costs than issuing 1 year note and rolling it over.
 Other Benefits:
 Designed to appeal to money market mutual funds which face tight
investment restrictions
9.Warrants to Purchase Debt Securities
 Distinguishing Feature:
 Warrants with 1- 5 years to expiration to buy
intermidiate or long term bonds.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Issuer is effectively selling a covered call option
which can afford investor opportunities not
available in the traditional option market.
10.Yield Curve Notes and Minimum
Rates Notes
 Distinguishing Feature:
 Interest rate equals a specifiad rate minus
LIBOR.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Might reduce yield relative to conventional debt when
coupled with an interest rate SWAP with LIBOR.
 Other Benefits
 Useful for hedging and immunization purposes because
of very long duration.
11.Zero Coupon Bonds (sometimes
issued in series)
 Distinguishing Feature:
 Non- interest bearing.
 Payment in lump sum at maturity.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Issuer assumes reinvestment risk. Issues sold in Japan
carried below- taxable market yield reflecting their tax
advantage over conventional debt issues.
 Tax Arbitrage:
 Straight line amortization of original issue discount pre-
TEFRA. Japanese investors realize significant tax savings.
 12.Puttable Bonds And Adjustable Tender
Securies.
 Distinguishing Feature:
 Issuer can periodically reset the terms, in effect rolling over
debt without having to redeem it until the final maturity.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Coupon based on whether fixed or floating rate and on length of the
interest rate period selected, not on final maturity.
 Reduction in Agency cost:
 Investor has a put option, which provides protection against
deterioration in credit quality or below market coupon rate.
 Reduction in Transaction costs:
 Lower transaction costs than having to perform a series of refunding.
13. Dual Currency Bonds
 Distinguishing Feature:
 Interest payable in US dollars but principal payable
in a currency other than US dollars.
 Properties:
 Risk Reallocation/ Yield Reduction:
 Issuer has foreign currency risk with respect to principal repayment
obligation.
 Currency swap can hedge the risk and lead, in some cases, to yield
reduction.
 Other Benefits:
 Euro yen- dollar dual currency bonds popular with Japanese
investors who are subject to regulatory restrictions and desire
income in dollars without principal risk.
14. Euronotes and Euro-commercial
paper
 Distinguishing Feature:
 Euro-commercial paper is similar to US-
commercial paper
 Properties:
 Risk Reallocation:
 Elimination of intermediary brings savings that
lender and borrower can share
 Reduction in Transaction Cost:
 Corporations invest in each other’s paper directly
rather than through an intermediary
15. Extendible notes
 Distinguishing Feature:
 Interest rate adjusts every 2-3 years to a new interest
rate the issuer establishes at which time note holder
has the option to put the notes back to the issuer if the
new rate is unacceptable.
 Properties:
 Risk Reallocation:
 Coupon based on 2-3 year put date, not on the final maturity.
 Reduction in Agency Cost:
 Investor has a put option which provides protection against
deterioration in credit quality or below market coupon rate.
 Reduction in Transaction Cost:
 Lower transaction costs than issuing 2 or 3 year notes and rolling
them over.
16. Additional Class(es) of Common
Stock
 Distinguishing Feature:
 A company issues a second class of common
stock the dividends on which are tied to the
earnings of a specified subsidiary.
 Properties:
 Other Benefits:
 Establishes separate market value for the subsidiary while
assuring the parent 100% voting control. Useful for
employee compensation programs for subsidiary.
17. Americus Trust
 Distinguishing Feature:
 Outstanding share of a particular company’s common stock are
contributed to a five year unit investment trust. Units may be
seperated into a PRIME component , which embodies full
dividend and voting rights in the underlying share and permits
limited capital appericiationabove a stated price.
 Properties:
 Risk Reallocation
 Stream of annual total returns on a share of stock is seperatd into (i) a dividend
stream (with limited capital appreciation potential) and (ii) a (residual) capital
appreciation stream.
 Tax Arbitrage:
 PRIME component would appeal to corporate investors who can take
advantage of 70% dividends received reduction. SCORE component would
appeal to capital-gain-oriented individual investors.
 Other Benefits:
 Prime component resembles participating prefferd stock if the issuer common
stock dividend rate is stable. SCORE component is longer dated call options
than the ones customarily traded in options market.
18. Master Limited Partnership
 Distinguishing Feature:
 A business is given the legal form of a
partnership but is otherwise structured, and is
traded publicly, like a corporation.
 Properties:
 Tax Arbitrage:
 Eliminates a layer of taxation because partnership
are not taxable entities.
19. Puttable Common Stock
 Distinguishing Feature:
 Issuer sells a new issue of common stock along with
rights to put the stock back to the issuer on a
specified date at a specified price.
 Properties:
 Risk Reallocation
 Issuer sells investor a put option, which investors will exercise if the
company’s share decreases.
 Reduction in Agency Cost:
 The put option reduces agency cost associated with a new share issue
that are brought on by informational asymmetries
 Other Benefits:
 Equivalent under certain conditions to convertible bonds but can be
recorded as equity on the balance sheet so long as the company’s
payment obligation under the put option can be settled in common
stock.
20. Adjustable rate notes and floating rate
notes
 Distinguishing Feature:
 Coupon rate floats with some index.

 Properties:
 Risk allocation/yield reduction
 Issuer exposed to floating interest rate risk.
 Enhanced liquidity
 Price remains closer to par than the price of a fixed
rate note of the same maturity.
 21.Auction rate notes and debentures

 Distinguishing Feature:
 Interest rate reset by Dutch auction at the end of each
interest period
 Properties:
 Risk Reallocation/ Yield Reduction:
 Coupon based on length of interest period not on final maturity.
 Reduction in Transaction Costs:
 Lower Transaction costs than issuing than repeatedly rolling over
shorter maturity securities.
 Other Benefits:
 Designed to trade closer to par value than a floating rate loan
with a fixed interest rate formula.
 22. Bonds linked to commodity price or
index
 Distinguishing Feature:
 Interest or/and principal linked to a specific
commodity price or index .
Properties:
 Risk Reallocation/ Yield Reduction:
 Issuer assumes commodity price or index risk in return for lower
coupon.it can serve as an hedge if the issuer produces the particular
commodity.
 Other benefits
 attractive to investors who want to speculate in commodity options
but can not for regulatory reasons
23. Commercial real estate backed bonds
 Distinguishing Feature:
 These bonds are serviced and backed by a
specific piece of real estate .

 Properties:
 Risk Reallocation/ Yield Reduction:
 Reduced yield due to greater liquidity.
 Other Benefits
 Appeals to investors who want to lend against real
estate.
24. Credit Enhanced Debt Securities
 Distinguishing Feature:
 Issuer’s obligation to pay is backed by an
irrevocable letter of credit

 Properties:
 Risk Reallocation/ Yield Reduction:
 Stronger credit rating of the letter of credit leads to
lower yield.
 25. Collateralized Mortgage Obligations

 Distinguishing Feature:
 Mortgage payment stream is divided into several classes
which are prioritized in terms of their right to receive
principal repayments .

 Properties:
 Risk Reallocation/ Yield Reduction:
 Reduction in prepayment risk to classes with prepayment
priority designed to appeal to different classes of investors .
 Reduction in Transaction costs:
 Most investors could not achieve the same degree of
prepayment risk reduction as cheaply on their own.
26. Variable Coupon Renewable
Notes
 Distinguishing Feature
 Coupon rate varies weekly and equals a fixed spread
over the 91- day T-bill rate.
 Each 91 days the maturity extends another 91-days.
 If put exercised spread is reduced.

 Properties
 Coupon based on 1- year termination date
 Lower transactional costs than issuing 1- year note
 Designed to appeal to money market mutual funds.
27. Floating Rate Notes
 Distinguishing Feature
 Coupon rate resets quarterly based on a spread over
LIBOR.
 Spread increases if the issuer’s debt rating increases.

 Properties
 Issuer exposed to floating interest rate risk.
 Price remain close to par than the price of a fixed- rate
note of the same maturity.
 Investor protected against deterioration in the issuer’s
credit quality.
28. Floating rate tax exempt revenue
bond
 Distinguishing Feature
 Coupon rate floats with some index such as the 60-
day high grade commercial paper rate.

 Properties
 Issuer exposed to floating interest rate risk.
 Initial rate is lower than for fixed rate issue.
 Investor does not have to pay income tax on the
interest payments but issuer gets to deduct them.
29. Increasing rate notes
 Distinguishing Feature
 Coupon rate increases by specified amount at
specified interval

 Properties
 Defers portion of interest expense to later years,
which increases duration.
30. Indexed currency option notes
 Distinguishing Feature
 Issuer pay reduced principal at maturity if specified
foreign currency appreciates

 Properties
 Investor assumes foreign currency risk by effectively
selling the issuer a call option denominated in the
foreign currency.
 Attractive to investors who would like to speculate in
foreign currency but cannot.
31. Adjustable Rate Convertible Debt
 Distinguishing Characteristics:
 Debt the interest rate on which varies directly
with the dividend rate on the underlying
common stock. No conversion premium.
 Properties:
 Tax Arbitrage: Effectively, Tax deductable
common equity. Security has once been ruled
as equity by the IRS.
 Other Benefits: Portion of the issue carried as
equity on the issuer’s balance sheet.
32. Convertible Exchangeable
Preferred Stock
 Distinguishing Characteristics:
 Convertible preferred stock that is exchangeable, at
the issuer’s option, for convertible debt with identical
rate and identical conversion terms.
 Properties:
 Reduction in Transaction Costs: No need to reissue convertible
security as debt- just exchange it- when the issuer becomes a
tax payer.
 Tax Arbitrage: Issuer can exchange debt for the preferred when
it becomes taxable with interest rate the same as the dividend
rate and without any change in conversion features.
 Other Benefits: Appears as equity on the issuer’s balance sheet
until it is exchanged for convertible debt.
33. Convertible Reset Debentures
 Distinguishing Characteristics:
 Convertible bond the interest rate on which
must be adjusted upward if necessary, by an
amount sufficient to give the debentures a
market value equal to their face amount 2 years
after issuance.
 Properties:
 Reduction in agency cost: Investor is protected
against a deterioration in the issuer’s financial
prospects within 2 years of issuance.
34. Debt with Mandatory Common
Stock Purchase Contracts
 Distinguishing Characteristics:
 Notes with contracts that obligate note purchasers to
buy sufficient common stock from the issuer to retire
the issue in full by its scheduled maturity date.
 Properties:
 Tax Arbitrage:
 Notes provide a stream of interest tax shields, which (true)
equity does not.
 Other Benefits:
 Commercial bank holding companies have issued it
because it continued as “ primary capital” for regulatory
purposes.
 35. Exchangeable Auction Preferred
Stock
 Distinguishing Characteristics :
 Auction rate preferred stock is exchangeable on any dividend payment
date, at the option of the issuer, for auction rate notes, the interest rate on
which is reset by Dutch auction every 35 days.
 Properties:
 Risk Reallocation:
 Issuer bears more interest rate risk than a fixed- rate instrument would involve.
 Enhanced Liquidity:
 Security is designed to trade near its par value.
 Reduction in its transaction costs:
 Issuance of auction rate notes involve no underwriting commissions.
 Tax Arbitrage:
 Issuer can exchange notes for the preferred when it becomes taxable.
 Other Benefits:
 Appears as equity on the issuer’s balance sheet until it is exchanged for auction traded
notes.
36. Synthetic Convertible Debt
 Distinguishing Characteristics:
 Debt and warrants package structured in such
a way as to mirror a traditional convertible
debt issue.
 Properties:
 Tax Arbitrage:
 In effect, warrant proceeds are tax deductible.
 Other benefits:
 Warrants go on the balance sheet as equity.
 37.Puttable Extendible Notes
 Distinguishing Feature:
 At the end of each interest period, the issuer may elect to redeem
the notes at par or to extend the maturity on terms the issuer
proposes at which time the note holder can put the notes back to
the issuer, if the new terms are unacceptable.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Coupon based on length on interest interval not on final maturity.
 Reduction in Agency cost:
 Put Options protect against deterioration against issuer credit
standing and also against issuer setting below market coupon rate
or other terms that might work to investor’s disadvantage.
 38. Real Yield Securities
 Distinguishing Feature:
 Coupon rate resets quarterly to the greater of:
1. Change in consumer price index plus the real yield
spread.
2. The real yield spread in each case on a semi
annual equitant basis.
 Properties:
 Risk Reallocation/ Yield Reduction:
 Issuer exposed to inflation risk which may be hedged in the CPI
future markets.
 Reduction in Transaction costs:
 Investors obtain a long dated inflation hedging instrument that
they could not trade as cheaply on their own.
 39.Receivables pay through Securities.

 Distinguishing Feature:
 Investor buys an undivided interest in a pool of
receivables.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Reduced yield due to the benefits to the investor of
diversification and greater liquidity, significantly cheaper
for issuer than pledging receivables to a bank.
 Reduction in Transaction costs:
 Security purchasers could not achieve the same degree of
diversifications as cheaply on their own.
 40.Remarketed Reset Notes.
 Distinguishing Feature:
 Interest rate reset at the end of each interest period to a rate the remarketing
agent determines will make the Notes worth par. If issuer and remarketing agent
cannot agree on the rate, then the coupon rate is determined by formula which
dictates a higher rate the lower the issuer’s credit standing.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Coupon based on length of interest period not on final maturity.
 Reduction in Agency cost:
 Investor s have a put option which protects against the issuer and remarketing
agent to set a below market coupon rate and the flexible interest rate formula
protects investors against deterioration in the issuer’s credit standing.
 Reduction in Transaction costs:
 Intended to have lower transaction cost than auction rate, notes and debentures
which require periodic Dutch auctions.
 41.Strict Mortgage Backed Securities.

 Distinguishing Feature:
 Mortgage payment stream subdivided in to two classes:
1. One with below market coupon and other with above market
coupon or,
2. One receiving interest only and other receiving principle
only from mortgage pools.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Securities have unique options characteristics that make them
useful for hedging purposes. Designed to appeal to different
classes of investors, sum of the parts can exceed the whole.
 42.Stripped Treasury
 Distinguishing Feature:
 Coupon separated from corpse to create a series of
Zero coupon bonds that can be sold separately.

 Properties:
 Risk Reallocation/ Yield Reduction:
 Yield curve arbitrage, sum of the parts can exceed
the whole.
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