hybrid securities

Prof. Ian GiddyNew York University

Hybrid Securities

DBS Bank

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

CORPORATE FINANCEDECISONS

INVESTMENT RISK MGTFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

MEASUREMENT

FINANCING ALTERNATIVES AVAILABLE TO MAJOR CORPORATIONS

EQUITY

Subsidized funds

Privateplacement

Publicoffering

Revolvingfacility

Term loan

Real estate

Leasing

Assetbacked

Unsecured

Domestic

Eurobond

Floating

Longterm

Shortterm

Euro CP

Bank debt

Dollar

Non-dollar

ARPFRN

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?

When Debt and Equity are Not Enough

Valueof future

cash flows

Claims onthe cash flows

Assets Liabilities

Valueof future

cash flows

Contractual int. & principalNo upsideSenior claimsControl via restrictions

Assets LiabilitiesDebt

Residual paymentsUpside and downsideResidual claimsVoting control rights

Equity

Valueof future

cash flows

Equity

What if...

Claims are inadequate?

Returnsare inadequate?

Valueof future

cash flows

Equity

Alternatives Collateralized Asset-securitized Project financing

Preferred Warrants Convertible

Prof. Ian GiddyNew York University

Hybrid Financial Instruments

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

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?

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

Debt orequity are

Not good enough

A Day in the Life...

NEW INTER NA TIONAL BO ND ISSUESBo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r ic ePr ic e M a t ur ityM a t ur ity F ee sFee s 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 re dit Suisse

M ar ui 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 De utsche 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 r ants. Private plac em ent. C onvertible. (a) Non-callable. (b) C allable at par af ter 5 year s. I f call notexe rcise d, bond pays 50bp over Libor in last year . (c) Rede mption linked to Nikkei stock index .

NEW INTER NA TIONAL BO ND ISSUESBo r rowe rBo r rowe r Am ou nt m .Am ou nt m . C ou pon %C ou pon % P r ic ePr ic e M a t ur ityM a t ur ity F ee sFee s 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 re dit Suisse

M ar ui 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 De utsche 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 r ants. Private plac em ent. C onvertible. (a) Non-callable. (b) C allable at par af ter 5 year s. I f call notexe rcise d, bond pays 50bp over Libor in last year . (c) Rede mption linked to Nikkei stock index .

Equity-Linked Eurobonds

Eurobonds with warrantsMarui

Convertible EurobondsBattle Mountaingold

Index-linked EurobondsBank of Montreal

Warrants

TheoreticalValue

Market ValueMarket Premium

ValueofWarrant

0 Price Per Share of Common Stock ($)

Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

ValueofConvertibleBond

($) 0Price Per Share of Common Stock

Nikkei-Linked

28,00019,000

PRINCIPALREPAYMENT

Bank of Montreal Nikkei-Linked Note

Bank of Montreal

Japanese insurance companies

US pension fund with Japan

portfolio

Bankers Trust Nippon Credit

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.

Medium-Term Notes:Anatomy of a Deal

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.

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

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.

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

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.

The Issue

Issuer: Deutsche Bank AG Amount: US$ 40 Million Coupon:

First three years: semi-annualLIBOR + 3/8% p.a., paid semi-annuallyLast 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

The Deal in Detail

SCOTTISHLIFE

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

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.

Option Pricing

Option Price= Intrinsic value + Time value

Option Price

UnderlyingPrice

Time value depends on Time Volatility Distance from the strike price

Option Pricing Model

93 93 94 94 95 95 96 96FUTURES PRICE

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

Value of Call Option

INTRINSIC VALUE TIME VALUE

EXPECTED VALUE OF PROFITGIVEN EXERCISE

STRIKE

FUTURESPRICE

SHADED AREA:Probability distribution of

the log of the futures price on the expiration date for values above the strike.

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.

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?

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$

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?)

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.

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)

Why Innovations Fail

The rationale evaporates It’s too costly It’s New Coke

Case Study:Banpu Convertible

How did this work? Why did Banpu use this technique? Why did investors buy it?

Banpu Convertible

Thai Time

1994 1997 1999 2004

www.giddy.org

Ian GiddyNYU Stern School of BusinessTel 212-998-0332; Fax 212-995-4233ian.giddy@nyu.eduhttp://www.giddy.org

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