3 Main Financial Instruments | Foreign Exchange

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3 Main Financial Instruments

This article throws light upon the three main financial instruments. They are: 1. Euro Notes and Euro Commercial Papers 2. Banker’s Acceptance and Letters of Credit 3. Repurchase Agreement.

Financial Instrument # 1. Euro Notes and Euro Commercial Papers:

Both Euro notes and Euro commercial papers are short-term instruments, unsecured promissory notes issued by corporations and banks. Euro notes, the more general term, encompasses note- issuance facilities, those that are underwritten, as well as those are not underwritten.

The term Euro commercial papers is generally taken to mean notes that are issued without being backed by underwriting facility – that is without the support of medium term group of banks to provide funds in events that ate borrower is unable to role over its Euro notes on acceptable terms. These Euro Commercial papers are an unsecured, short- term loan issued by a bank or corporation in the international money market, denominated in a currency that differs from the corporation’s domestic currency.

For example, if a US corporation issues a short-term bond denominated in Canadian dollars to finance its inventory through the international money market, it has issued euro commercial paper.

CP represents a cheap and flexible source of the fund while CP are negotiable, secondary market lend to be not very active and most investors hold the paper to maturity. The rates of interest are cheaper than bank looks and this instrument is issued only by high rated borrowers. Euro Commercial paper has emerged only very recently. Commercial paper is a money market security issued by large banks and corporations.

It is generally not used to finance long-term investments but rather to purchase inventory or to manage working capital. Because commercial paper maturities do not exceed nine months and proceeds typically are used only for current transactions, the notes are exempt from registration as securities with the United States Securities and Exchange Commission.

Financial Instrument # 2. Banker’s Acceptance and Letters of Credit:

A bankers’ acceptance, or BA, is a time draft drawn on and accepted by a bank. It is a time draft drawn on and accepted by a bank. Before acceptance, the draft is not an obligation of the bank; it is merely an order by the drawer to the bank to pay a specified sum of money on a specified date to a named person or to the bearer of the draft. Upon acceptance, which occurs when an authorized bank accepts and signs it, the draft becomes a primary and unconditional liability of the bank.

If the bank is well-known and enjoys a good reputation, the accepted draft may be readily sold in an active market. A banker’s acceptance is also a money market instrument – a short-term discount instrument that usually arises in the course of international trade.

A banker’s acceptance starts as an order to a bank by a bank’s customer to pay a sum of money at a future date, typically within six months. At this stage, it is like a postdated check. When the bank endorses the order for payment as “accepted”, it assumes responsibility for ultimate payment to the holder of the acceptance.

At this point, the acceptance may be traded in secondary markets much like any other claim on the bank. Bankers’ acceptances are considered very safe assets, as they allow traders to substitute the banks’ credit standing for their own.

They are used widely in international trade where the creditworthiness of one trader is unknown to the trading partner. Acceptances sell at a discount from face value of the payment order, just as US Treasury bills are issued and trade at a discount from par value.

Acceptances arise most often in connection with international trade. For example, an American importer may request acceptance financing from its bank when, as is frequently the case in international trade, it does not have a close relationship with and cannot obtain financing from the exporter it is dealing with.

Once the importer and bank have completed an acceptance agreement, in which the bank agrees to accept drafts for the importer and the importer agrees to repay any drafts the bank accepts, the importer draws a time draft on the bank. The bank accepts the draft and discounts it; that is, it gives the importer cash for the draft but gives it an amount less than the face value of the draft. The importer uses the proceeds to pay the exporter.

The bank may hold the acceptance in its portfolio or it may sell, or rediscount, it in the secondary market. In the former case, the bank is making a loan to the importer; in the latter case, it is in effect substituting its credit for that of the importer, enabling the importer to borrow in the money market.

On or before the maturity date, the importer pays the bank the face value of the acceptance. If the bank rediscounted the acceptance in the market, the bank pays the holder of the acceptance the face value on the maturity date.

Letters of credit are documents issued by banks in which the bank promises to pay a certain amount on a certain date, if and only if documents are presented to the bank as specified in terms of the credit. A letter of credit is generally regarded as a very strong legal commitment on the part of banks specified in terms of letters of credit.

In typical export transactions, the exporter will want to be paid once the goods arrive in foreign port. So, the exporter asks for acceptance of importers bank of time draft and that essentially would be an invoice that requests a money market instruments.

Financial Instrument # 3. Repurchase Agreement:

1. Repurchase agreements (RPs or repos) are financial instruments used in the money markets and capital markets. A more accurate and descriptive term is Sale and Repurchase Agreement — cash receiver (seller) sells securities now, in return for cash, to the cash provider (buyer), and agrees to repurchase those securities from the buyer for a greater sum of cash at some later date, that greater sum being all of the cash lent and some extra cash (constituting interest, known as the repo rate).

2. A reverse repo is simply a repurchase agreement as described from the buyer’s viewpoint, not the seller’s. Hence, the seller executing the transaction would describe it as a ‘repo’, while the buyer in the same transaction would describe it a ‘reverse repo’. So, ‘repo’ and ‘reverse repo’ are exactly the same kind of transaction, just described from opposite viewpoints.

3. A repo is economically similar to a secured loan, with the buyer receiving securities as collateral to protect against default. However, the legal title to the securities clearly passes from the seller to the buyer, or “investor”.

4. Although the underlying nature of the transaction is that of a loan, the terminology differs from that used when talking of loans due to the fact that the seller does actually repurchase the legal ownership of the securities from the buyer at the end of the agreement. So, although the actual effect of the whole transaction is identical to a cash loan, in using the ‘repurchase’ terminology, the emphasis is placed upon the current legal ownership of the collateral securities by the respective parties.

5. Although repos are typically short-term, it is not unusual to see repos with a maturity as long as two years.

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