Are Impact Bonds Derivatives ?

For this lesson, it’s highly recommended to refer to the Impact Evaluation module on the Theory of Change framework and the publication Wildlife Conservation Bond Saving Rhinos For Tomorrow. Wildlife Conservation Bond has an extensive read on Blended Capital.

The OECD defines blended finance as the strategic use of development finance to mobilize additional finance towards sustainable development in developing countries. Today, blended capital is driving additional private capital within the development sector. A strategic financial tool, blended finance enhances financial innovation for social good. The means to attract additional capital for implementation of SDGs through governments, foundations, development finance institutions through concessional (soft loans with lower interest rates and/or longer repayment duration) or non-concessional resources or public or private relationships gives a defining new policy perspective to blended finance. The key objective of blended finance is to catalyze the implementation of Sustainable Development Goals globally.

Image: The middle Road 

Blended Finance offers private investors a first loss guarantee, mezzanine, or senior debt to cushion against potential losses with actors from the development space, i.e., donors, multilateral development banks, and development finance institutions taking equity first loss. Various instruments are used to mobilize capital like Shares in CIVs, Guarantees, Syndicate loans, credit lines, and direct investment in companies. The idea of catalytic first-loss capital evolved to attract capital from the private sector, especially institutional investors. Blended Finance uses various structures like first loss guarantee, senior and junior debt, junior equity to absorb risk by development institutions, donors, etc for scenarios where risk is high and returns low to attract investors for social and development projects.

Impact Bonds are strictly not bonds as the financial instrument is designed to pay for success or outcome-driven pay-out. This aspect gives it a contingent-driven outcome with a derivative-like quality. The middle Road classifies impact bonds as exotic derivatives structured like binary European call options. Recommended read —— Sustainable Banking: New Forms of Investing under the Umbrella of the 2030 Agenda by Mariano Méndez-Suárez, Abel Monfort, and Fernando Gallardo.

Whats are Options?

Options are derivative instruments. Derivatives are financial instruments whose value is based on an underlying asset. This asset could be a tradeable asset like listed shares of a company or derivatives on art or illiquid assets. They are two types of options; Call Option gives the holder the right but not the obligation to buy an asset at a specific price over a time period. Put Option gives the holder the right but not the obligation to sell an asset at a particular price over a time period. Options can be traded on Over the Counter or on exchange. The over-the-counter derivatives market is much bigger than the exchange traded derivatives market. The Global OTC Derivatives Market gross market value stood at $12.617 trillion at end of H1 2021, the notional amount at ~$610 trillion according to BIS data.

Options have an exercise price or strike price K built into the contract. Example Twitter is trading at $45.85. Let’s assume the option price on the Twitter stock is 1.76 for a strike price of 50. You buy options in lots i.e. options on 50, 100 stocks, etc. Ignore any other information, taking the maturity of the call option to be a month, you will buy a Twitter stock only if the stock crosses (50+1.76) = 51.76, otherwise you will not use the option. The 1.76 premium paid per stock here will be your loss. If the stock trades at 55, you will buy the stock at 50 and sell it in the market for 55, making a profit of 55-50-1.76 = $3.24.

There are two types of options American and European. American options can be exercised at any time during the life of the option, the European option is exercised only at the end of the maturity. The period of the option is known as expiration date or maturity, the price of the derivative contract is exercise price or strike price. Options trading on the exchanges are standardized and much more liquid than an option that is traded over the counter. These options are known as plain vanilla options.

Exotic Options or Exotics are structured according to the specific needs of the investor. Binary options are exotic options that are created to meet specific needs – (cash or nothing call) with discontinuous payoff. Binary Options are specific types of options where payment can be cash or nothing. A call holder gets cash if the price of the underlying asset is above a value otherwise the payout is zero. Since impact bonds are outcome-driven with no certainty of payment (consider here outcome-driven payment is the equity impact payment in case of Cameroon Cataract Bond) they work as a European Exotic Call Option. Each periodic payment is structured as a separate exotic call option dependent on the strike price. The strike price is equated to K which is the outcome.

Cameroon Cataract Bond 

Below is the outcome pay-out structure of Cameroon Cataract Bond as mentioned in the Cameroon Cataract Bond: A case study produced as part of the Cameroon Cataract Bond Evaluation. OPIC and Netri Foundation are the outcome funders. The bond has two types of targets – performance and impact targets. For this example, we will ignore performance target and focus on impact target. This bond we discussed before targets cataract surgeries for population in Cameroon.  

At the end of the five-year bond, a bonus payment of $120K is paid to the service provider if 40 percent of the surgeries are administered to the bottom two income quintiles of the population in Cameroon. This is where the bond is focusing on the underprivileged section of the society.

Take the equity pay-out to the service provider as a type of binary European Call option pay-out. If the impact target is not achieved, the equity payout is zero, otherwise, the payment of $120K is made to the service provider. In this case, 39.99 percent of the surgeries administered for a target population is the strike price K. The payout follows the binary option pay out structure.  

There will be a follow up with a basic derivatives module for a better understanding of these instruments.