Prof. Ian Giddy New York University Hybrid Securities DBS Bank
Dec 21, 2015
Copyright ©2000 Ian H. Giddy Hybrid Securities 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?
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Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
FINANCING ALTERNATIVES AVAILABLE TO MAJOR CORPORATIONS
DEBT
EQUITY
Subsidized funds
Privateplacement
Publicoffering
Revolvingfacility
Term loan
Real estate
Leasing
Assetbacked
Unsecured
Domestic
Eurobond
Fixed
Floating
Longterm
Shortterm
US CP
Euro CP
Bank debt
MTN
Dollar
Non-dollar
ARPFRN
VRN
StraightHybrid
Callable
Index-linked
Convertible
With warrants
Restricted
Full rights
Private sale
Public offering
Domestic
International
Equity options
Stripped
Unstripped
Projectfinance
Bankdebt
Debt?
Equity?
What kind?
Debt?
Equity?
What kind?
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When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Claims on
the cash flows
Claims on
the cash flows
Assets Liabilities
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When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
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When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
What if...
Claims
are inadequate?
Returns
are inadequate?
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When Debt and Equity are Not Enough
Value
of future
cash flows
Value
of future
cash flows
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Contractual int. & principal
No upside
Senior claims
Control via restrictions
Assets Liabilities
Debt
Residual payments
Upside and downside
Residual claims
Voting control rights
Residual payments
Upside and downside
Residual claims
Voting control rights
Equity
Alternatives
Collateralized Asset-securitized Project financing
Preferred Warrants Convertible
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Managing Hybrid Securities
Principles of hybrid instruments Market imperfections as motives for
hybrids Hybrids in the Eurobond market:
Asset-backed securitiesWarrant bonds and convertiblesIndex-linked bonds
Application: callable bonds
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A Day in the Lifeof the Eurobond Market
Examine the dealsWhy were each done in that particular
form?What determines the pricing?
Can you break the hybrids into their component parts?
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Why Use a Hybrid?
Motivations for Hybrids
Linked to business risk
Linked to
market risk
Cannot hedge
with derivatives
Driven by investor needs
Company hedges
Company does not
hedge
Debt or
equity are
Not good enough
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A Day in the Life...
NEW INTER NA TIONAL BO ND ISSUES
Bo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r iceP r ice M a t ur ityM a t ur ity F eesF ees Boo k ru nn erBoo k ru nn er
C elworks Trust 1990-1¶ (b) US $250 9 1/4 99.80 1998 1 7/8-1 5/8 C redit Suisse
M arui Corp* US $500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nom ura
Holderbank ( a) US $150 9 3/4 101 1994 1 3/8-1 C SF B
Battle M ountaingold US $100 7 1/2 100 2006 2 1/2-1 1/2 M er rill Lynch
SN CF F Fr750 9 1/4 98.55 1997 1 7/8-1 1/4 C C F
Viennische Stadtsba nk (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofim a (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank
Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IB J
Bank of M ontreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon C re dit
¶F inal te rm s. *With equity war rants. P rivate plac em ent. C onvertible. (a) Non-callable. ( b) C allable at par af ter 5 year s. I f c all notexe rcised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
NEW INTER NA TIONAL BO ND ISSUES
Bo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r iceP r ice M a t ur ityM a t ur ity F eesF ees Boo k ru nn erBoo k ru nn er
C elworks Trust 1990-1¶ (b) US $250 9 1/4 99.80 1998 1 7/8-1 5/8 C redit Suisse
M arui Corp* US $500 (4 3/ 8) 100 1995 2 1/4-1 1/2 Nom ura
Holderbank ( a) US $150 9 3/4 101 1994 1 3/8-1 C SF B
Battle M ountaingold US $100 7 1/2 100 2006 2 1/2-1 1/2 M er rill Lynch
SN CF F Fr750 9 1/4 98.55 1997 1 7/8-1 1/4 C C F
Viennische Stadtsba nk (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BN L
Eurofim a (a ) P ta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank
Ir ish Bldg Soc . (a ) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IB J
Bank of M ontreal (c ) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon C re dit
¶F inal te rm s. *With equity war rants. P rivate plac em ent. C onvertible. (a) Non-callable. ( b) C allable at par af ter 5 year s. I f c all notexe rcised, bond pays 50bp over Libor in last year . (c) Redemption linked to Nikkei stock index .
Copyright ©2000 Ian H. Giddy Hybrid Securities 14
Equity-Linked Eurobonds
Eurobonds with warrantsMarui
Convertible EurobondsBattle Mountaingold
Index-linked EurobondsBank of Montreal
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Warrants
TheoreticalValue
Market ValueMarket Premium
Value
of
Warrant
($)
0Price Per Share of Common Stock ($)
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Convertibles
ConversionValue
StraightBond Value
Market ValueMarket Premium
Value
of
Convertible
Bond
($) 0
Price Per Share of Common Stock
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Bank of Montreal Nikkei-Linked Note
Bank of Montreal
Japanese insurance companies
US pension fund with Japan
portfolio
Bankers Trust Nippon Credit
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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.
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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-.10Is not too concerned about specific timing
of issue, amount or maturityIs willing to consider hybrid structures.
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Anatomy of a Deal
Investor:Has distinctive preference for high grade
investmentsLooking for investments that will improve
portfolio returns relative to relevant indexesInvests in both floating rate and fixed rate
sterling and dollar securitiesCan buy options to hedge portfolio but
cannot sell options
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Anatomy of a Deal
Intermediary:Has experience and technical and legal
background in structure financeHas active swap and option trading and
positioning capabilitiesHas clients looking for caps and other
forms of interest rate protection.
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The Deal
1 Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures
2 Structuring a MTN in such a way as to meet the investor’s needs and constraints
3 Line up all potential counterparties and negociate numbers acceptable to all sides
4 Upon issuer’s and investor’s approval, place the securities
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The Deal / 2
5 For the issuer, swap and strip the issue into the form of funding that he requires
6 Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.
Copyright ©2000 Ian H. Giddy Hybrid Securities 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
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The Deal in Detail
SCOTTISH
LIFE
CSFB
DEUTSCHE
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)
CLIENT
CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise
Copyright ©2000 Ian H. Giddy Hybrid Securities 32
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.
Copyright ©2000 Ian H. Giddy Hybrid Securities 33
Option Pricing
94.5
Option Price
= Intrinsic value + Time value
Option Price
Underlying
Price94.75
Time value depends on Time Volatility Distance from the strike price
Time value depends on Time Volatility Distance from the strike price
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Option Pricing Model
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
93 93 94 94 95 95 96 96FUTURES PRICE
CA
LL O
PT
ION
PR
ICE
ENTER THESE DATA:=================
-> FUTURES PRICE 94.75-> STRIKE PRICE 94.5-> TIME IN DAYS 300-> INTEREST RATE 7-> STD DEVIATION 15
CALL PRICE IS......... 0.40PUT PRICE IS....... 0.17
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Value of Call Option
INTRINSIC VALUE TIME VALUE
EXPECTED VALUE OF PROFIT
GIVEN EXERCISE
STRIKE
FUTURES
PRICE
SHADED AREA:
Probability distribution of the log of the futures price on the expiration date for values above the strike.
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Black-Scholes Option Valuation
Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 - (T1/2)
whereCo = Current call option value.
So = Current stock price
N(d) = probability that a random draw from a normal distribution will be less than d.
Copyright ©2000 Ian H. Giddy Hybrid Securities 37
Breaking Down a Convertible: Unisys
At the end of 1992, Unisys had a convertible bond, coming due in 2000, which was trading at $1400. It also had straight bonds, with the same maturity, trading in December 1992 at a yield of 8.4%. What’s the straight bond component
worth?What’s the convertible option worth?
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Breaking Down a Convertible: Unisys
Coupon rate on Convertible Bond = 8.25%Market Interest Rate on Straight Bond of same Risk = 8.40%Price of Convertible Bond = 1400Maturity of Convertible Bond = 8
Value of Straight Bond Portion = 991.51$ Value of Conversion Option = 408.49$
Coupon rate on Convertible Bond = 8.25%Market Interest Rate on Straight Bond of same Risk = 8.40%Price of Convertible Bond = 1400Maturity of Convertible Bond = 8
Value of Straight Bond Portion = 991.51$ Value of Conversion Option = 408.49$
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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?)
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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.
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What Conditions Permit Hybrids to Thrive?
Government Rules and RegulationsExample: Japan Air Lines Yen-linked Eurobond
Tax DistortionsExample: Money Market Preferred
Constraint on Issuers or InvestorsExample: Nikkei-Linked Eurobond
Segmentation-Driven InnovationExample: Collateralized Mortgage Obligations
(CMOs)
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Why Innovations Fail
The rationale evaporates It’s too costly It’s New Coke
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Case Study:Banpu Convertible
How did this work? Why did Banpu use this technique? Why did investors buy it?
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www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
http://www.giddy.org