In the past, it was challenging for lenders to assess a borrower's creditworthiness, which resulted in high credit risks. However, things have changed since that time. It is common practice for most lenders to check a borrower's creditworthiness through credit ratings. These credit ratings usually come from agencies known as credit rating agencies. Before understanding what these agencies are, it is crucial to look at what credit ratings mean. What is a Credit Rating?A credit rating is a measure of a borrower's creditworthiness, represented in the form of a quantifiable score. Every borrower with a history of credit dealings will have a credit rating, which they can get from credit rating agencies. However, there is no standard for credit ratings that these agencies give to borrowers. Instead, it represents the agency's opinion of a particular individual's creditworthiness. Through credit ratings, lenders can assess the default or credit risk associated with their debts. In simpler words, they can gauge the likeliness of the borrower defaulting on the debt. Using credit ratings, lenders can decide whether they should provide a loan to a specific borrower. Similarly, these ratings allow the lender to dictate the terms for each loan. What is a Credit Rating Agency?A credit rating agency is a company that measures a borrower's creditworthiness in the form of credit ratings. As mentioned, these agencies provide their opinion of how likely it is for a borrower to default. Credit rating agencies consider several factors when assessing a borrower's credit rating, including their past transaction histories. There are several agencies that can provide credit ratings to borrowers. Among these, the top names include Moody's Investor Services, Standard and Poor's (S&P), and Fitch Group. These are considered the big three credit agencies around the world. These three companies control 95% of the global credit rating market. How do Credit Rating Agencies work?Credit rating agencies analyze borrower's credit histories and assign a rating to them based on those transactions. Borrowers may include individuals, companies, organizations, or any entity that requires loans from a lender. Credit rating agencies may request the borrower to provide documentation related to their past credit dealings. For example, a credit rating agency may require companies to provide their financial statements, bank records, loan records, etc., to evaluate their credit rating. Using these, the rating agencies assess whether the borrower made timely payments, their future economic potential, current debts held, credit mix, etc. Based on these, they provide a score to the borrower. Why is the importance of Credit Rating Agencies?Credit rating agencies are critical for both lenders and borrowers because they issue credit ratings. For lenders, these ratings provide a benchmark to filter any potential defaulters and reduce their default risk. Similarly, it allows them to set interest rates on any loan transactions with potential borrowers. Overall, it provides them with protection against any future losses. For borrowers, credit ratings can be helpful in securing loans. Similarly, borrowers with a higher credit rating score will get better and more favourable terms in their loan transactions. Usually, the fee charged by credit rating agencies for providing a rating is worth it for borrowers as it can reduce their interest expenses. Credit rating agencies also provide risk measures for various entities. It allows investors to understand the credit risks for those entities. For example, these agencies rate company bonds and other debt instruments. It helps investors in making better decisions about their investment based on the credit rating. ConclusionCredit ratings are a measure of a borrower's creditworthiness that comes from credit rating agencies. Credit rating agencies provide their opinion of a borrower's creditworthiness. Usually, they consider various factors, such as a borrower's history, current financial position, credit mix, etc. Article Source Here: What Is A Credit Rating Agency
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When making investment decisions in a company, investors consider various factors. Among these, profits are the most crucial as they can impact the investors' future returns. However, a company's earnings may not be meaningful if it has cash flow problems or operational inefficiencies. There are two terms, closely related to each other, which describe these problems, illiquidity, and insolvency. Some investors may confuse these two due to their similar nature. However, it is crucial to differentiate between them for better decisions. The term illiquidity is the opposite of liquidity, while insolvency is the antonym of solvency. What is Illiquidity?Before understanding what illiquidity is, it is crucial to define liquidity. Liquidity is a company's ability to meet its current liability obligations from the current assets it has. A company's liquidity shows whether it has sufficient resources to repay all its current liabilities without using its long-term assets. Liquidity is a term often associated with a company's cash flow and working capital management. Illiquidity is the opposite of liquidity. When a company does not have enough current assets to meet its current liabilities, it is considered illiquid. Illiquid companies can face financial problems in the future. Usually, these companies have to reside in obtaining finance to meet their operations or generating assets internally. Investors don't prefer investing in companies that have liquidity issues. For investors, an investment's liquidity shows how easily they can convert it into cash. Therefore, investors can easily obtain cash for a highly liquid investment as compared to an illiquid one. Usually, if an investment has an active market, investors will find it easier to convert it into cash. These may include stocks, which they can trade on stock markets. Similarly, they may consist of readily convertible government bonds. Investors can calculate a company’s liquidity ratios to determine whether an investment is illiquid. These include ratios such as current, cash, quick ratios. Although illiquid investments are problematic, these issues usually resolve in a short while. What is Insolvency?Insolvency is the opposite of solvency. Solvency shows a company’s ability to run its operations in the long run. A company’s financial position plays a crucial role in its long-term operations. Therefore, solvency defines a company’s long-term financial position. It considers a company’s total assets and liabilities compared to current assets and liabilities for liquidity. Insolvency represents a state of financial distress for companies in meeting their obligations. It can have a long-lasting effect on a company’s operations. Insolvency can also cause an eventual liquidation or legal actions against the company. There are several factors that can contribute to a company’s insolvency. Unlike illiquidity, the factors that cause insolvency come from long-term decisions. Similarly, there are different types of insolvencies that companies may face. These may include cash flow or balance sheet insolvencies. For investors, insolvent companies can create many problems. However, companies that face insolvency can also recover. Like illiquid investments, investors also steer clear of investing in insolvent companies. Investors usually use ratios such as the debt-to-equity ratio, debt-to-asset ratio, interest coverage ratio, etc., to determine if a company is insolvent. ConclusionInvestors consider various aspects of an investment when making a decision. Among these, two crucial aspects are illiquidity and insolvency. Illiquidity is when a company does not have enough current assets to meet its current liability obligations. On the other hand, insolvency is when a company does not have enough total assets to satisfy its total liabilities. Article Source Here: Illiquidity vs Insolvency Capital structure defines the mix of debt and equity finance that a company has at its disposal. Every company utilizes a different combination of several finance sources to increase their benefits while decreasing costs. Companies can make a decision about their capital structure by using various models or theories. One of these includes the pecking order theory of capital structure. What is the Pecking Order Theory?The pecking order theory suggests that companies should prefer finance sources generated internally to those available from external sources. This internal finance source comes in the form of retained earnings that companies generated from their operations. If a company does not have this option, it can collect funds from external sources. From external finance sources, the pecking order theory suggests that companies should prefer debt finance first. It is because debt is usually cheaper compared to other sources of finance. If a company does not have the option to raise finance through debt, it can generate finance through equity. According to the theory, companies should only use equity finance as a last resort when none of the other finance sources is available. How does the Pecking Order Theory work?Unlike other theories regarding capital structure, the pecking order theory does not establish an optimum capital structure. Instead, it focuses on minimizing costs. As mentioned, this theory suggests that companies must prefer internally-generated finance sources. It is because these sources are the least costly for companies. Secondly, the pecking order theory prefers debt finance over equity finance. It is because debt finance is inexpensive compared to equity. As a last resort, this theory also allows companies to utilize equity finance. By using finance sources in that order, the pecking order theory enables companies to send a positive signal to their investors and the market. When a company uses finance that it generates internally, it increases its capital without any additional costs. Similarly, the costs related to debt finance are lower than equity finance. On top of that, using debt finance allows the management to signal that it is confident that a company can meet its repayment obligations. Lastly, using equity finance sends a negative signal, suggesting the company's stock is overvalued. What is the importance of the Pecking Order Theory?The pecking order theory is valuable for several reasons. Firstly, it provides a direction for companies to establish a capital structure. Similarly, it allows companies to minimize the costs related to financing. The pecking order theory also provides guidance to verify how information asymmetry affects the cost of financing a company. As mentioned above, the pecking order theory also allows a company's management to send signals to the market. Usually, using internally-generated finance sources or debt finance can have a positive impact on stock prices. What are the limitations of the Pecking Order Theory?The pecking order theory has several limitations. Firstly, this theory establishes an ideal pecking order for capital structure. Practically, it may not be possible for a company to follow that order. Similarly, this theory limits the types of funding that companies can use. It also does not consider other finance sources, such as hybrid instruments. The primary limitations of the pecking order theory come from its theoretical nature. On top of that, the theory is outdated and does not consider the challenges faced when establishing capital structures. ConclusionThe pecking order theory proposes an order for companies to use when establishing a capital structure. This theory suggests that companies should prefer internally-generated finance sources first. When that is not possible, these companies should use debt finance. Only as a last resort, companies should utilize equity finance. Article Source Here: Pecking Order Theory of Capital Structure Behavioural economics studies the psychology that relates to the decision-making process of investors. It looks at how investors allow psychological factors to impact their decisions. It goes against traditional finance theories, which assume that individuals don't let biases affect their decision-making. Behavioural economics also studies the subsequent effects on the markets of the decisions made by investors. There are various areas of behavioural economics that are relevant to investors. There are some theories that also describe how individuals make choices when faced when multiple options. One of these is the prospect theory. What is Prospect Theory?The prospect theory suggests that investors value gains and losses differently. Therefore, investors make decisions based on the expected gains rather than the estimated losses. In essence, the theory looks at how investors make decisions when presented with various options that involve risks, probability, and uncertainty. The prospect theory suggests that when investors are given various choices with the same probabilities, they will make decisions based on gains. Therefore, they are more likely to choose decisions that will ascertain that they will retain their wealth rather than increase it. In short, this theory suggests that investors will choose the option shown in terms of gains rather than one presented in loss terms. How does Prospect Theory work?The prospect theory of behavioural economics comes from the work of two psychologies, Amos Tversky and Daniel Kahneman. They formed a basis to describe how people make decisions when faced with various choices. They developed the prospect theory by framing risky choices. Their study suggested that people are loss-averse as they dislike losses more than equivalent gains. Another name for the prospect theory is the "loss-aversion" theory, as it describes the behaviour of risk-averse individuals. The theory primarily proposes that losses cause a greater emotional impact on decision-makers. Therefore, investors react differently to potential losses and potential gains. The theory also suggests that people make decisions based on potential gains or losses relative to their situation. What are the phases of Prospect Theory?The prospect theory proposes that there are two faces to the decision-making process of individuals. These are as follows. Editing PhaseThe editing phase is the initial phase when individuals characterize options for a choice. It is known as framing effects. Framing effects describe the way in which the order, method, or wording of the substance of choice differs according to the presentation. Once an individual goes through this phase, they can enter the second phase of prospect theory. Evaluation PhaseThe evaluation phase suggests that individuals are likely to behave as if they can give a value to each outcome. Usually, they make a decision based on the potential consequences and go with the option that has a higher utility. The evaluation phase depends on statistical analysis to measure and compare each outcome of a given decision. This phase consists of two-component elements. These are the value function and the weighting function ConclusionProspect theory comes from behavioural economics and suggests that decision-makers perceive losses and gains differently. This theory describes the risk-averse behaviour shown by individuals when presented with several choices. It also proposes that individuals make decisions based on gains on losses based on their situations. The prospect theory has two phases, including the editing and the evaluation phase. Post Source Here: What Is Prospect Theory? What is Behavioural Finance?Behavioural finance is a field of behavioural economics that deals with investors' psychological influences and biases. It studies how these influences and biases affect the financial behaviour that investors use in investing decisions. Similarly, behavioural finance also explores market anomalies, specifically in the stock market. It looks at how influences and biases can cause these anomalies to exist. Behavioural finance opposes any traditional finance theories in various regards. For example, some traditional theories assume that investors do not allow biases or influences to affect their decisions. However, behavioural finance tackles that by suggesting that investors make decisions under the influence of biases. There are several concepts in behavioural finance that explain how investors behave in the stock market. One of these includes anchoring, which can further lead to anchoring bias. Before understanding what anchoring bias is, it is crucial to understand the concept of anchoring in behavioural finance. What is Anchoring in Behavioural Finance?Anchoring refers to attaching a spending level to a certain reference. It is when investors put too much reliance on historical information or the first information they find. Usually, this information is irrelevant. Since investors find this information to existing beforehand, they put more reliance on it than they should. Overall, anchoring is the use of irrelevant information for decision-making. Anchoring gives rise to anchoring bias, which can lead to incorrect financial decisions. For example, when an investor holds to a stock, despite making losses. It is because they stick to their original estimates for profitability. This way, they are oblivious to any relevant data that may exist. Anchoring occurs when investors make estimates about various stocks. Since they start the process with an initial value and make adjustments to it, they are likely to stick to their initial value. This process of sticking or holding to the initial decisions or estimates is known as anchoring. Overall, anchoring can lead to incorrect decisions because of initial perception. Investors generally ignore this bias if they isolate the decision. However, since they look at everything from an initially biased perspective, they are likely to make the wrong decision. What is Anchoring Bias?Anchoring bias is a bias that stems from the concept of anchoring. Anchoring bias is when investors make incorrect financial decisions by basing these decisions on one point of information. Based on this starting point, investors tend to form an initial opinion. During any subsequent transactions, investors let the bias influence their decisions based on that opinion. Anchoring bias exists in all markets and for all investors. Usually, it is prevalent in decision-making areas where investors need to make estimates or use historical information. Although this information may not be irrelevant anymore, investors tend to favour it when making decisions. According to behavioural finance, anchoring bias can cause investors to reject rational choices. Anchoring bias can cause many problems for investors in financial markets. This bias can lead investors to look at past investment performance for a product and assume the same trend will continue in the future. Similarly, it can cause investors to delay their investment decisions, such as selling an investment. Anchoring bias can make investors biased toward new information. Through all of these, investors can make incorrect decisions and suffer losses. ConclusionBehavioural finance is an area of behavioural economics that deals with how investors allow psychological influences and biases to affect their decisions. Anchoring is a concept in behavioural finance that relates to when investors put overreliance on irrelevant information. Anchoring bias is the bias that comes from anchoring. Originally Published Here: Anchoring in Behavioral Finance A company's capital structure defines the mix of equity and debt finance used to finance its activities. For every company, the capital structure will differ based on its needs and usage. This combination of equity and debt finance may also vary during a period or from one year to another. A company’s capital structure is a crucial part of its financial position. Deciding on a capital structure to use for a company is a strategic-level decision. Companies consider various factors when choosing the right mix of equity and debt finance to use in their operations. There are several approaches or theories that can help them in this decision-making. One of these is the static trade-off theory. What is the Static Trade-Off Theory?The static trade-off theory is relevant for capital structure. This theory focuses on finding a balance between equity and debt finance that companies use. The static trade-off theory balances both types of finance by establishing a point where the combined benefits from both are at a maximum. Similarly, it tries to minimize the costs related to using each type of finance. Static trade-off theory comes from the 1950s based on the works of Modigliani and Miller. However, it is a theory that opposes their work rather than supporting it. Modigliani and Miller studied the capital structure theory and proposed capital structure irrelevance, in which they stated that a company’s capital structure is irrelevant for its value. However, the static trade-off theory opposed that view by proposing an optimal point for capital structure. At this proposed point, this theory believes that the capital structure costs will be the lowest while also maximizing the benefits. The static trade-off theory also relates to the Weighted Average Cost of Capital (WACC). How does the Static Trade-Off Theory work?The static trade-off theory bases its view on the capital structure irrelevance theory from Modigliani and Miller. However, it opposes one of the assumptions made by the theory. The capital irrelevance theory assumes that there are no costs to financial distress when companies borrow finance. By removing this assumption, the static trade-off theory allows companies to establish an optimal capital structure point. The statistic trade-off theory suggests that a company's debt finance is initially cheaper. It is because debt is tax-deductible and involves lesser risks for a company compared to equity. Therefore, a company can, in theory, decrease its weighted average cost of capital by accumulating debt finance. Theoretically, having a capital structure financed fully by debt finance will be much cheaper than an equity-financed capital structure. However, debt finance comes with diminishing returns. The more debt a company accumulates, the higher its risks will be. At a specific point, the risks will exceed the benefits that companies get from this finance source. Companies would want to avoid reaching a point where the costs of debt finance exceed their benefits. The static trade-off theory aims to identify the point at which debt finance has the maximum benefits. In short, this theory tries to identify the mix of equity and debt finance, where decreasing WACC and increasing financial risk offset each other. ConclusionA company’s capital structure refers to the combination of equity and debt finance it uses for its operations. Managing the capital structure is crucial for companies. There are several theories that help companies establish an optimal capital structure. One of these is the static trade-off theory. This theory seeks to find a point at which the benefits from the capital structure at a maximum. Post Source Here: Static Trade-Off Theory What is Hedging?Hedging is a process that investors use to protect their finances from any risks. In other words, hedging is the process that investors use to mitigate their risks. They do so to reduce the chances of losses or offset their assets against the losses. Hedging is also useful in limiting the loss the investors make and introduce certainty to a transaction. Hedging is a common practice in many industries. Any entity, including individuals, companies, organizations, etc., can use hedging as a method to reduce their risks. There are many techniques that are available when hedging against risks. Usually, these techniques involve using financial instruments that derive their value from an underlying security or asset. These are known as derivatives. However, there are some disadvantages to hedging. Since hedging is a process used to reduce risks, it can also result in the loss of potential rewards. Entities that use hedging also lose their profits while they choose certainty over their returns. Usually, hedging involves two parties. One party accepts the risks of the other party while also benefiting from the transaction in several ways. Hedging is common through the use of derivatives. These include options, futures, forward contracts, and swaps. One technique common among these is interest rate swaps. What is an Interest Rate Swap?An interest rate swap is a financial derivative that investors use to swap their interest payments with another party. Interest rate swaps are necessary for mitigating the risks involved with floating interest rate instruments. Usually, these contracts involve the exchange of a floating-rate debt instrument with a fixed-rate instrument. With interest rate swaps, participants can mitigate the risks associated with their debt instruments. For most participants, interest rate swaps are a powerful hedging technique. When the interest rates in the market are uncertain or volatile, entities can use interest rate swap hedging to achieve certain interest payments. Like every other hedging technique, interest rate swaps include at least two participants. One party usually accepts to pay a floating rate interest on the other party's behalf. In exchange, the opposite party gets to make a fixed interest payment. There are several terms that both parties define in these contracts to ensure a smooth process. Usually, both parties decide on the principal amount of the swap. Once they do so, they define the rates for the contract. The contract will also include the length for which the swap will be applicable and any other terms. Once both parties agree to it, they will sign the contract, making the contract effective. Interest Rate Swap Hedging ExampleA company, ABC Co., has a floating interest rate loan with a principal amount of $1 million. The company expects interest rates in the market to increase in the future. Therefore, it wants to hedge against the risk of losses in the future. Another company, XYZ Co., has a fixed interest rate loan with the same principal amount. Both companies agree to enter an interest rate swap contract. With this contract, ABC Co. will be responsible for paying XYZ Co.'s interest payments and vice versa. In case the market interest rates increase, ABC Co. will pay a fixed interest payment and benefit from it. Contrarily, if the market interest rates drop, XYZ Co. will profit. Through the interest rate swap contract, ABC Co. can hedge its interest rate risks. For XYZ Co., the swap contract is also beneficial. In case the market interest rates drop, the company will get favourable payment terms. Therefore, both companies can use interest rate swaps to hedge against the risks of rising interest payments. ConclusionHedging is a process that entities, whether individuals or companies, use to mitigate risks. There are many techniques that are available to hedge against those risks. One of these includes interest rate swaps. These are contracts that participants use to mitigate the risks associated with interest rates. Post Source Here: Interest Rate Swap Hedging Example A convertible bond is a type of bond that comes with the right to convert the debt into equity instruments. Investors that invest in these bonds get the benefits of other debt instruments while also getting the option to receive equity investments. Convertible debts come with interest payments and face value like other debt instruments. However, they also have an equity instrument due to the conversion option involved. Due to the complex nature of convertible bonds, accounting for convertible bonds is complicated. Similarly, the convertible bond tax treatment is also crucial to understand. The tax treatment of convertible bonds may differ according to the bond's current stage. Given below are details of how this treatment works. Purchase of Convertible BondWhen an investor purchases a convertible bond, there is no taxable event. It is because acquiring convertible bonds do not create any income or value for investors. Instead, it results in an increase of assets for the debtholder. There may be tax implications if the holder transfers a capital asset in exchange for the debt. However, the purchase itself is not taxable. Holding Period of Convertible BondAs mentioned, convertible bonds come with all debt instrument features. Therefore, investors holding convertible bonds will receive interest payments according to a predetermined coupon rate. This interest is subject to income taxes according to the interest rules that apply to other interest payments. Investors are also subject to tax implications if they purchase the bond at a discount or premium. Sale of Convertible BondAs with traditional bonds, investors have the option to sell a convertible bond before maturity. In this case, there are some tax implications for the investor. Usually, when investors dispose of a convertible bond, they will create a capital gain or loss for themselves. It represents the difference between the bond's original price and the fair market value of the proceeds received. The investor will also have to adjust the convertible bond’s price to reflect any accrued but unpaid interest at the disposal date. Once they do so, they will have to pay the tax on the capital gain according to the applicable capital gain taxation rules. Investors can also receive tax deductions in case of capital losses on the sale. However, there are some rules that may classify the gain on disposal as normal income rather than capital gain. For instance, it may occur when there is an accrued market discount on the debt at the disposal date. In that case, normal income tax rules will apply instead of capital gain taxes. Conversion of Convertible BondIf an investor chooses to convert a convertible bond into equity instruments, they will not be subject to taxation. It is because the tax laws view the conversion as a transformation of ownership rather than a disposition. Therefore, the debtholder will not be subject to any taxes on conversion even if there is a difference between the bond and equity instrument's value. Investors will have to pay taxes for any stock they receive in exchange for any accrued interest on the bond. This case only applies if the investor hasn't already paid taxes on the accrued interest. At conversion, the interest payments to the investor will also stop. Therefore, taxation on interest payments will also end. ConclusionConvertible bonds are instruments that include a debt and equity component. Convertible bond tax treatment differs according to the stage in which investors are. Usually, investors have to pay taxes on convertible bonds for the interest received. Similarly, they also have to pay taxes on the sale of the bond. Originally Published Here: Convertible Bond Tax Treatment Risk represents the probability that the actual results differ from the expected results. Entities, including individuals, companies, organizations, and other bodies, face risk in their transactions. It also includes the possibility that losses occur for these entities. When transacting in financial markets, facing risks is inevitable. However, there are various ways in which entities can mitigate their risks. One of the techniques used by entities for risk management is hedging. Hedging is the process that companies use to mitigate risks through the use of financial derivatives. This process is common across various financial markets. Entities that use hedging must also account for the process using hedge accounting. What is Hedge Accounting?Hedge accounting is the process through which companies or businesses record the effect of risk management activities. They do so to present these effects in the financial statements. Hedge accounting comes under the provisions of the IFRS 9 - Financial Instruments. According to the standards, risk management activities can affect a company's profit or loss (P&L) or other comprehensive income (OCI). Hedge accounting modifies the traditional basis that companies use to record gains and losses on associated hedging instruments. The purpose is to satisfy the matching principle in accounting, which requires companies to account for gains and losses in the accounting period to which they relate. However, the use of hedge accounting is optional according to the requirements of IFRS 9. Hedge accounting applies to various hedge contracts and items. These include options, forward contracts, futures, swap contracts, etc. It also includes interest rate swaps, where two parties exchange their interest payments. It usually involves one party transferring a floating interest rate instrument's interest payment for a fixed interest payment. What are the Hedge Accounting models?IFRS 9 retains three hedge accounting models that are a part of IAS 39. These include fair value, cash flow, and net investment hedges. In fair value hedges, entities mitigate the risk of changes in an asset's or liability's fair value. Cash flow hedges are when a participant hedges the risk of variability in cash flows attributable to a specific risk associated with a recognized asset or liability. Net investment hedges are when an entity hedges the currency risk associated with translating foreign operation net assets. Foreign operations include subsidiaries, joint ventures, associates, etc., held in foreign locations. How do companies account for Interest Rate Swap in Hedge Accounting?Before companies use hedge accounting to account for interest rate swaps, they must ensure the contract qualifies for hedge accounting. There are some criteria that a hedge contract must meet to qualify for this treatment. Once companies establish that the swap meets the conditions, they must determine why they are using the interest rate swap. If a company uses interest rate swaps to hedge exposure to fair value changes of a fixed debt, it will have to account for it as a fair value hedge. This treatment will apply even if the company accounts for the debt instrument at amortized cost. Companies must measure hedging instruments at fair value with gains and losses recognized in the P&L under this method. If a company uses interest rate swaps to change floating rate debt to fixed-rate debt, then the cash flow hedge treatment will apply. Under this treatment, the company must recognize the changes in the hedging instrument's fair value in the OCI. It must also accumulate those instruments in a cash flow reserve within equity. However, there are some treatments that the company will have to take to the P&L as well. ConclusionHedge accounting is a process through which companies can account for their hedging contracts. Hedge accounting may also apply to interest rate swaps, given that these swaps meet specific criteria. Interest rate swap in hedge accounting may come under the fair value or cash flow hedge model. Article Source Here: Interest Rate Swap in Hedge Accounting Investing in a company’s equity instruments is straightforward. Investors pay to receive a company’s stock, which gives them the right to receive dividends and voting rights. However, there are some instruments that investors can convert into equity instruments in the future. Among these, the two common ones that investors usually confuse include convertible bonds and warrants. What is a Convertible Bond?A convertible bond comes with the option to allow investors to convert the bonds into ordinary shares. Usually, these include features of both debt and equity instruments. The debt features include face value, interest payments, maturity period, etc. On the other hand, the equity feature includes conversion in ordinary shares. Most importantly, convertible bonds come with conversion terms. These terms define the number of shares that investors will get for each unit of debt they hold. For example, a company may issue a convertible bond that allows investors to convert each $100 of debt to 10 ordinary shares. Usually, investors have the option to choose to convert or receive their cash back. There are some other types of convertible bonds that may make it mandatory for investors to convert their bonds. Similarly, a reversible convertible bond allows the company to choose whether the investor can convert to shares or not. However, the most common type of convertible bond is the vanilla convertible bond that gives the investor the right. The most critical characteristic of convertible bonds that separates them from warrants is the debt component. Until its maturity, a convertible bond behaves like traditional bonds. Investors can get interest payments for the time they hold the bond. Similarly, the conversion price for these bonds is predetermined and agreed upon by both parties at the issuance date. What is a Warrant?A warrant (or stock warrant) is an instrument that companies issue to investors that gives them the option to purchase their stock at a specific price within a specific time period. Similar to vanilla convertible bonds, the investor has the option to exercise their right with warrants. They do not have any obligation to convert in the future. With warrants, investors get to purchase a company's newly issued stock at a future date. Usually, they get the stock at a lower rate than prevalent in the market. During the time that investors hold warrants, they do not get any interest payments or dividend distributions. It is one of the distinguishing features between convertible bonds and warrants. When investors purchase a warrant, they receive a warrant certificate. This certificate includes details of the warrant, such as the expiry date or purchase price. Usually, investors can get a call warrant that allows them the right to buy shares at a specific time in the future at a specific price. However, they can also get put warrants that come with the right to sell back shares at a specific price in the future. Some warrants may also come in the form of bonds. Usually, however, warrants don't have any intrinsic value of their own. Investors can think of warrants as convertible bonds without the debt component. While warrants offer better profit-making chances in the future, convertible bonds come with more certainty. ConclusionA convertible bond is a type of bond that comes with the right to convert the debt into an equity instrument. These bonds include both debt and equity characteristics. A warrant allows investors to buy or sell a company's stock for a specific price within a specific time in the future. It comes with a conversion option as well. However, warrants don't include the debt characteristics common to convertible bonds. Article Source Here: Convertible Bond vs Warrant |
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