Mitigating risk on bankers’ acceptances
By Elias Mugabe
IN this article we will look at ways of mitigating risk when trading in risky instruments such as bankers’ acceptances and nego
tiable certificates of deposit.
A banker’s acceptance is an order that is made by a company and addressed to a bank requiring it to pay a specified amount of money to the holder of the instrument unconditionally. The bank therefore acts as a guarantor and as such is obliged to pay the amount of investment upon maturity to the holder regardless of whether the bank has received payment from the company or not.
The party issuing the security has to pay a fee for services rendered by the bank. The market for bankers’ acceptances is quite significant and these bills have a high liquidity risk.
There are two types of bankers’ acceptances: ie eligible BAs or re-discountable bills and non-eligible bills. Eligible bills may be sold to the Reserve Bank of Zimbabwe (RBZ) in order to cover shortages. Non-eligible bills are drawn to finance long-term investments such as fixed capital outlays and purchase of stocks. They are mainly used to finance local transactions.
These bills are not liquid and as such pose high liquidity risk to the investor. This is also due to the fact that they cannot be sold to the RBZ and therefore demonstrate the unsteady nature in their trading rates which reflects most readily the state of the money market. The return from an investor’s notion is generally lucrative.
The other risk that is attached to these instruments is specific to the company from whom it is drawn and the bank that guarantees the paper. The investor should therefore make a due diligence of the bank guaranteeing the transaction and the underlying borrower.
When trading in bankers’ acceptances the following issues must be critically analysed by the fund manager or investor;
* A thorough due diligence must have been done before accepting BA’s on a buy back or outright basis and credit risk,liquidity risk, default riskmust be analy-sed thoroughly;
* The strength of the issuing bank or guaran-tor’s balance sheet footings must be eva-luated;
* The credibi-lity of the underlying borrower will be driven by the following variables: its ownership status, whether it is listed or not as well as the shareholding structure, ie it must have the right blend of both institutional and individual investors, historical and current financial performance of the company, any qualitative analysis information pertaining to the borrower, a valuation of the general trend of that particular industry, reasons for borrowing (working capital, capex or speculative borrowing), if a BA is being drawn from a bank different from the one selling it, authenticity of the paper must be verified, and security being offered by the borrower.
When trading on buy backs, limits based on counter parties’ balance sheets must be set.
However, these limits must take note of volatility in the money market and our economy in general and the need for the fund/investor to create value for the fund.
In view of the challenges poised by this financial instrument, it might be imperative to set limits that are constantly reviewed in line with the total assets under management. Ideally, the only personnel who can authorise such transactions should be the head of investments or an investment committee.
NCDs Negotiable certificates of deposits are instru-ments are more like the above with the only difference being that NCDs are negotiable and can be sold in an organised secondary market.
The risk that is attached to these instruments is mainly liquidity risk that is brought about by the thin market.
The interest rate is determined in the market unlike bank deposits with fixed interest rates.
These instruments are issued in bearer form with a term to maturity ranging from overnight to two years.
The instrument shows the name of the issuing bank, issue date, maturity date, amount of the deposit, maturity value and the rate of interest.
High rate of default and inflation risk are the other areas of risk attached to this instrument.
Next week we will conclude on managing risk on the local money market by touching on other risky investment instruments such as corporate bonds and commercial paper.
* Elias Mugabe is the finance & risk director of Imperial Asset Man-agement Company andcan be contacted thro-ugh email: emugabe @impeass.co.zw