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Hybrid Securities

Hybrid Securities. DBS Bank. Prof. Ian Giddy New York University. The Agenda. What determines the optimal mix of debt and equity for a company? How does altering the mix of debt and equity affect the value of a company? What is the right kind of debt for a company?. Corporate Finance.

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Hybrid Securities

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  1. Hybrid Securities DBS Bank Prof. Ian Giddy New York University

  2. The Agenda • What determines the optimal mix of debt and equity for a company? • How does altering the mix of debt and equity affect the value of a company? • What is the right kind of debt for a company?

  3. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY TOOLS M&A

  4. Debt? Equity? What kind?

  5. When Debt and Equity are Not Enough Assets Liabilities Value of future cash flows Claims on the cash flows

  6. When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights

  7. When Debt and Equity are Not Enough What if... Assets Liabilities Claims are inadequate? Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Returns are inadequate? Equity Residual payments Upside and downside Residual claims Voting control rights

  8. When Debt and Equity are Not Enough Alternatives Assets Liabilities Collateralized Asset-securitized Project financing Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Preferred Warrants Convertible Equity Residual payments Upside and downside Residual claims Voting control rights

  9. Hybrid Financial Instruments Prof. Ian Giddy New York University

  10. Managing Hybrid Securities • Principles of hybrid instruments • Market imperfections as motives for hybrids • Hybrids in the Eurobond market: • Asset-backed securities • Warrant bonds and convertibles • Index-linked bonds • Application: callable bonds

  11. A Day in the Lifeof the Eurobond Market • Examine the deals • Why were each done in that particular form? • What determines the pricing? • Can you break the hybrids into their component parts?

  12. Why Use a Hybrid? Motivations for Hybrids Linked to business risk Driven by investor needs Linked to market risk Company hedges Company does not hedge Cannot hedge with derivatives Debt or equity are Not good enough

  13. A Day in the Life...

  14. Equity-Linked Eurobonds • Eurobonds with warrants • Marui • Convertible Eurobonds • Battle Mountaingold • Index-linked Eurobonds • Bank of Montreal

  15. Warrants V a l u e o f W a r r a n t ($) 0 Market Value Market Premium Theoretical Value Price Per Share of Common Stock ($)

  16. Convertibles Conversion Value Straight Bond Value V a l u e o f C o n v e r t i b l e B o n d ($) 0 Market Value Market Premium Price Per Share of Common Stock

  17. Nikkei-Linked PRINCIPAL REPAYMENT 19,000 28,000

  18. Bank of Montreal Nikkei-Linked Note Bankers Trust Bank of Montreal Nippon Credit Japanese insurance companies US pension fund with Japan portfolio

  19. Structured Notes • Bundling and unbundling basic instruments • Exploiting market imperfections (sometimes temporary) • Creating value added for investor and issuer by tailoring securities to their particular needs Key: For the innovation to work, it must provide value added to both issuer and investor.

  20. Medium-Term Notes:Anatomy of a Deal

  21. Anatomy of a Deal Issuer: • Looking for large amounts of floating-rate USD and DEM funding for its loan porfolio. • Wants low-cost funds: target CP-.10 • Is not too concerned about specific timing of issue, amount or maturity • Is willing to consider hybrid structures.

  22. Anatomy of a Deal Investor: • Has distinctive preference for high grade investments • Looking for investments that will improve portfolio returns relative to relevant indexes • Invests in both floating rate and fixed rate sterling and dollar securities • Can buy options to hedge portfolio but cannot sell options

  23. Anatomy of a Deal Intermediary: • Has experience and technical and legal background in structure finance • Has active swap and option trading and positioning capabilities • Has clients looking for caps and other forms of interest rate protection.

  24. The Deal • Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures • Structuring a MTN in such a way as to meet the investor’s needs and constraints • Line up all potential counterparties and negociate numbers acceptable to all sides • Upon issuer’s and investor’s approval, place the securities

  25. The Deal / 2 • For the issuer, swap and strip the issue into the form of funding that he requires • Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.

  26. The Issue • Issuer: Deutsche Bank AG • Amount: US$ 40 Million • Coupon: First three years: semi-annual LIBOR + 3/8% p.a., paid semi-annually Last 5 years: 8.35% • Price: 100 • Maturity: February 10, 2000 • Call: Issuer may redeem the notes in full at par on February 10, 1995 • Fees: 30 bp • Arranger: Credit Swiss First Boston

  27. The Deal in Detail DEUTSCHE SCOTTISH LIFE Deutsche sells 3-year floating rate note paying LIBOR - 3/8% For an additional 3/4% p.a., Deutsche buys three- year put option on 5-year fixed-rate 8.35% note to SL in 3 years For 1% p.a., Deutsche sells CSFB a swaption (the right to pay fixed 8.35% for 5 years in 3 years) CSFB CLIENT CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise

  28. What’s Really Going On? Note: • Issuer has agreed to pay an above-market rate on both the floating rate note and the fixed rate bond segment of the issue FRN portion: .75 % above normal cost Fixed portion: .50% above normal cost • Issuer has in effect purchased the right to pay a fixed rate of 8.35% on a five-year bond to be issued in three years time.

  29. Option Pricing Time value depends on • Time • Volatility • Distance from the strike price Option Price Option Price = Intrinsic value + Time value Underlying Price 94.5 94.75

  30. 93 93 94 94 95 95 96 96 Option Pricing Model 1.8 1.6 1.4 1.2 1 CALL OPTION PRICE 0.8 0.6 0.4 0.2 0 FUTURES PRICE

  31. Value of Call Option SHADED AREA: Probability distribution of the log of the futures price on the expiration date for values above the strike. FUTURES PRICE STRIKE INTRINSIC VALUE TIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE

  32. Black-Scholes Option Valuation Co = SoN(d1) - Xe-rTN(d2) d1 = [ln(So/X) + (r + 2/2)T] / (T1/2) d2 = d1 - (T1/2) where Co = Current call option value. So = Current stock price N(d) = probability that a random draw from a normal distribution will be less than d.

  33. Breaking Down a Convertible: Unisys • At the end of 1992, Unisys had a convertible bond, coming due in 2000, which was trading at $1400. It also had straight bonds, with the same maturity, trading in December 1992 at a yield of 8.4%. • What’s the straight bond component worth? • What’s the convertible option worth?

  34. Breaking Down a Convertible: Unisys

  35. Motivations for Issuing Hybrid Bonds • Company has a view • There are constraints on what the company can issue • The company can arbitrage to save money • Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)

  36. Economics of Financial Innovation • Certain kinds of market imperfections allow hybrids to flourish • But innovation are readily copied; so only certain kinds of firm can profit from innovations. • There is a product cycle and profitability cycle of innovations.

  37. What Conditions Permit Hybrids to Thrive? • Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond • Tax Distortions Example: Money Market Preferred • Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond • Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs)

  38. Why Innovations Fail • The rationale evaporates • It’s too costly • It’s New Coke

  39. Case Study:Banpu Convertible How did this work? Why did Banpu use this technique? Why did investors buy it?

  40. Banpu Convertible Huh?

  41. Thai Time 1997 1999 2004 1994

  42. www.giddy.org Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 212-995-4233 ian.giddy@nyu.edu http://www.giddy.org

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