Hybrid Securities - NYU Stern School of Business | Full ...pages.stern.nyu.edu/~igiddy/corpfin/Singapore/simhybrids.pdf · cash flows Value of future ... Managing Hybrid Securities

Giddy/SIM Hybrid Securities-1

Prof. Ian GiddyNew York University

Hybrid Securities

SIM/NYUThe Job of the CFO

Copyright ©2001 Ian H. Giddy Hybrid Securities 2giddy.org

The Agenda

l What determines the optimal mix of debt and equity for a company?

l How does altering the mix of debt and equity affect the value of a company?

l What is the right kind of debt for a company?



Corporate Finance

CORPORATE FINANCEDECISONS

CORPORATE FINANCEDECISONS

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?



When Debt and Equity are Not Enough

Valueof future

cash flows

Valueof future

cash flows

Claims onthe cash flows

Claims onthe cash flows

Assets Liabilities



Valueof future

cash flows

Valueof future

cash flows

Contractual int. & principalNo upsideSenior claimsControl via restrictions


Assets Liabilities

Debt

Residual paymentsUpside and downsideResidual claimsVoting control rights


Equity




Valueof future

cash flows

Valueof future

cash flows



Assets Liabilities

Debt



Equity

What if...

Claims are inadequate?

Returnsare inadequate?



Valueof future

cash flows

Valueof future

cash flows



Assets Liabilities

Debt



Equity

Alternatives

n Collateralizedn Asset-securitizedn Project financing

n Preferredn Warrantsn Convertible



Managing Hybrid Securities

l Principles of hybrid instruments

l Market imperfections as motives for hybrids

l Hybrids in the Eurobond market:uAsset-backed securities

uWarrant bonds and convertibles

uIndex-linked bonds

l Application: callable bonds


A Day in the Lifeof the Eurobond Market

l Examine the dealsuWhy were each done in that particular

form?

uWhat determines the pricing?

l 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

hedge

Debt orequity are

Not good enough


A Day in the Life...

NEW INTERNATIONAL BOND ISSUES

BorrowerBorrower Amount m.Amount m. Coupon %Coupon % PricePrice MaturityMaturity FeesFees Book runnerBook runner

Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse

Marui Corp* US$500 (4 3/8) 100 1995 2 1/4-1 1/2 Nomura

Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB

Battle Mountaingold!! US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch

SNCF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF

Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BNL

Eurofima (a) Pta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank

Irish Bldg Soc.! (a) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ

Bank of Montreal! (c) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit

¶Final terms. *With equity warrants. !Private placement. !!Convertible. (a) Non-callable. (b) Callable at par after 5 years. If call notexercised, bond pays 50bp over Libor in last year. (c) Redemption linked to Nikkei stock index.

NEW INTERNATIONAL BOND ISSUES

BorrowerBorrower Amount m.Amount m. Coupon %Coupon % PricePrice MaturityMaturity FeesFees Book runnerBook runner

Celworks Trust 1990-1¶ (b) US$250 9 1/4 99.80 1998 1 7/8-1 5/8 Credit Suisse

Marui Corp* US$500 (4 3/8) 100 1995 2 1/4-1 1/2 Nomura

Holderbank (a) US$150 9 3/4 101 1994 1 3/8-1 CSFB

Battle Mountaingold!! US$100 7 1/2 100 2006 2 1/2-1 1/2 Merrill Lynch

SNCF FFr750 9 1/4 98.55 1997 1 7/8-1 1/4 CCF

Viennische Stadtsbank (a) L100bn 13 101 3/8 1994 1 3/8-7/8 BNL

Eurofima (a) Pta10bn 12 5/8 101 1/8 1996 1 5/8-1 Deutsche Bank

Irish Bldg Soc.! (a) ¥15bn 7.4 101 5/8 1995 1 5/8-1 1/8 IBJ

Bank of Montreal! (c) ¥2.8bn 7 1/4 101 1/8 1993 1 1/8-5/8 Nippon Credit

¶Final terms. *With equity warrants. !Private placement. !!Convertible. (a) Non-callable. (b) Callable at par after 5 years. If call notexercised, bond pays 50bp over Libor in last year. (c) Redemption linked to Nikkei stock index.



Equity-Linked Eurobonds

l Eurobonds with warrantsuMarui

l Convertible EurobondsuBattle Mountaingold

l Index-linked EurobondsuBank of Montreal


Warrants

TheoreticalValue

Market Value

Market Premium

Value

of

Warrant

($)

0 Price Per Share of Common Stock ($)



Convertibles

ConversionValue

StraightBond Value

Market Value

Market Premium

Value

of

Convertible

Bond

($) 0

Price 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

l Bundling and unbundling basic instruments

l Exploiting market imperfections (sometimes temporary)

l 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.



Carps III

100% CAPITAL-PROTECTED ZERO-COUPON USD EMTN LINKED TO FRANK RUSSELL JAPAN EQUITY FUND

l Basic Structurel a. This is a USD Euro-Medium Term Note with a maturity of 3 years. l b. It carries a 100% capital guarantee on maturity (provided by

Societe Generale rated Aa3 by Moody’s and AA- by S&P) l c. Being a zero-coupon Note, the yield is linked to the performance of

the Frank Russell Japan Equity Fund.

l Client Suitabilityl Appropriate for ‘sophisticated investors’ who:l a. require only 100% guarantee on capital on maturityl b. believe that Japan is on a recovery path and that the stock market of

Japan will see significant gains over the medium term l c. believe that the Frank Russell Japan Equity Fund is capable of

delivering a consistently above-market return with reduced risks.


Carps III

l Client’s objectives

l The “Guaranteed Minimum Return” product

l How is this priced? Who else could benefit from it?

80 85 90 95 100

105

110

115

120

125

130

135

140

145

150

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Index Level at maturity (Initial index level = 100)

Profit (Loss) with 100% Principal ProtectionProfit (Loss) with 90% Principal Protection

Prof

it (L

oss)



Medium-Term Notes:Anatomy of a Deal


Anatomy of a Deal

Issuer:uLooking for large amounts of floating-rate

USD and DEM funding for its loan porfolio.

uWants low-cost funds: target CP-.10

uIs not too concerned about specific timing of issue, amount or maturity

uIs willing to consider hybrid structures.



Anatomy of a Deal

Investor:uHas distinctive preference for high grade

investments

uLooking for investments that will improve portfolio returns relative to relevant indexes

uInvests in both floating rate and fixed rate sterling and dollar securities

uCan buy options to hedge portfolio but cannot sell options


Anatomy of a Deal

Intermediary:uHas experience and technical and legal

background in structure finance

uHas active swap and option trading and positioning capabilities

uHas 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 andnegociate 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

l Issuer: Deutsche Bank AGl Amount: US$ 40 Millionl Coupon:

First three years: semi-annualLIBOR + 3/8% p.a., paid semi-annuallyLast 5 years: 8.35%

l Price: 100l Maturity: February 10, 2000l Call: Issuer may redeem the notes in full at par on

February 10, 1995l Fees: 30 bpl Arranger: Credit Swiss First Boston


The Parties in the Deal

SCOTTISHLIFE

CSFB

DEUTSCHE



The Deal in Detail

SCOTTISHLIFE

CSFB

DEUTSCHE

Deutsche sells 3-year floating rate note paying LIBOR - 3/8%


The Deal in Detail

SCOTTISHLIFE

CSFB

DEUTSCHE


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



The Deal in Detail

SCOTTISHLIFE

CSFB

DEUTSCHE



For 1% p.a., Deutsche sells CSFB a swaption(the right to pay fixed 8.35% for 5 years in 3 years)


The Deal in Detail

SCOTTISHLIFE

CSFB

DEUTSCHE



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:l 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

l 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

94.5

Option Price= Intrinsic value + Time value

Option Price

UnderlyingPrice

94.75

Time value depends onn Timen Volatilityn Distance from the strike price

Time value depends onn Timen Volatilityn Distance from the strike price



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


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 + σ2/2)T] / (σ T1/2)d2 = d1 - (σ 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

l 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%. uWhat’s the straight bond component

worth?

uWhat’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

Va lue of Straight Bond Portion = 991.51$

Va lue of Conversion Option = 408.49$


Motivations for Issuing Hybrid Bonds

l Company has a view

l There are constraints on what the company can issue

l The company can arbitrage to save money

l Always ask: given my goal, is there an alternative way of achieving the same effect (e.g., using derivatives?)



Economics of Financial Innovation

l Certain kinds of market imperfections allow hybrids to flourish

l But innovation are readily copied; so only certain kinds of firm can profit from innovations.

l There is a product cycle and profitability cycle of innovations.


What Conditions Permit Hybrids to Thrive?

l Government Rules and RegulationsExample: Japan Air Lines Yen-linked Eurobond

l Tax DistortionsExample: Money Market Preferred

l Constraint on Issuers or InvestorsExample: Nikkei-Linked Eurobond

l Segmentation-Driven InnovationExample: Collateralized Mortgage Obligations

(CMOs)



Why Innovations Fail

l The rationale evaporates

l It’s too costlyl It’s New Coke


Case Study:Banpu Convertible

nHow did this work?nWhy did Banpu use this technique?nWhy did investors buy it?



Banpu Convertible

Huh?


Thai Time

n 1994 n 1997 n 1999 n 2004


Prof. Ian GiddyNew York University

Leveraged Finance


M&A and Leverage

n Leveraged buyout?

Company has

unused debt

capacityn Leveraged

recapitalization?

n Takeover?



Typical LBO Sequence

Company gets bloated or slack and stock price falls

LBO offer made

LBO completed

Restructuring§Efficiencies§Divestiture

s§Financial

? years 3-9 months 5-7 years

IPO or sale of company


John M Case LBO

John Case,owner

Managers,buyersCompany

$20 million

Payment:n Bank debt $6mn Seller note $4mn Sub debt with warrants $9.5mn Manager’s equity $0.5m



Simplified Balance Sheet for a restructured J.M.Case Company

Assets Liabilities

21,266Total21,266Total

500Managers’ equity

9500Plug figure10084Good will

4000Case loan2184Fixed & other

6000Bank loan3236Other current

$1266Current Liab$5762Cash


John CaseCost of Capital

Liabilities Nominal Effective Weight ProductCurrent $1,266 0% 0.00% 5.95% 0.00%Bank loan $6,000 12% 8.40% 28.21% 2.37%Seller note $4,000 4% 8.17% 18.81% 1.54%VC plug $9,500 9% 21.40% 44.67% 9.56%Managers' equity $500 30% 2.35% 0.71%

$21,266 14.17%



giddyonline.com

Ian GiddyNYU Stern School of Business

Tel 212-998-0332; Fax 917-463-7629

[email protected]

http://www.giddy.org

Documents

Hybrid Securities - NYU Stern School of Business | Full ...pages.stern.nyu.edu/~igiddy/corpfin/Singapore/simhybrids.pdf · cash flows Value of future ... Managing Hybrid Securities