Convertible Bonds � The ProductPOPS Follow-up Presentation

17 November 2003

Martin Haycock (+44-20-7568 2282)

Convertible basicsSECTION 1

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Convertible versus straight bond

Straight bond

Pay 100 ... ... get 5% coupon each year ... ... get 100 back

Convertible bond

Pay 100 ... ... get 3% coupon ... CHOICE:... get 100 back or take 10 shares

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Terminology explained

Premium25%

Amount paid above today�s

share price

Conversion Today�s Premiumprice share price

�10 �8 25%

= +

Conversion ratio10 shares

Number of shares into which each bond converts

Nominal amount Conversion Conversionper bond ratio price

�100 10 shares �10

÷ =

Parity80%

Value of shares underlying bond

Conversion Today�s Parity ratio share price

10 �8 80%

x =

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Convertible becomes equity if share rises

Bo

nd

pri

ce /

par

ity

Launch Year 1 Year 2 Year 3 Year 4 Year 550

80

100

140

Parity

Bond price

Premium

Bond issued at 100 on 25% premium

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Convertible becomes a bond if share falls

Bo

nd

pri

ce /

par

ity

Launch Year 1 Year 2 Year 3 Year 4 Year 550

80

100

140

Conversion value

Bond price

Premium

Bond trends to 100 assuming issuer not going bust

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Convertible payoff

CB value

Stock price

Equity value

Bond floor

Bond Hybrid EquityDistressed

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It works in reality too...

0

50

100

150

200

250

300

Nov-98 Jan-00 Mar-01 May-02

(%)

Parity FT 2% 2004

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0

20

40

60

80

100

(%)

Convertibles�two ways to think of them

Bond �floor� moves with credit spread and interest rates, parity moves with the stock price

Bond + Call Stock + Put

Option value

Bond value

Conversionpremium

Conversion value (parity)

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Convertible termsheet�checklist

Maturity Status / ranking Denomination

Issue price Coupon Redemption price

Conversion ratio Conversion priceConversion premium

Issuer call Investor put Exchange property

Structures and valuationSECTION 2

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The spectrum of products

Equity

Convertibles can be debt-like or equity-like

Mandatories

Reset

Conventional

Premium redemption

Debt

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♦ Price to buy convertible remains at 100

♦ Conversion ratio stays at 10 shares

♦ Zero coupon

♦ But backload missing interest payments to maturity

Premium redemption convertibles

Pay 100 ... ... no coupon ...Pay 100 ... ... get 120 or 10 shares... no coupon ...(should be 3%)

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As well as convertibles, look out for �

Exchangeables

♦ Issued by Company A (credit risk)

♦ Converts into shares of Company B (equity risk)

♦ E.g. News Corp. into BSkyB

Mandatories

♦ Guaranteed conversion into stock

♦ Very equity-like as no downside protection

♦ Pay high coupon, e.g. DT 6.50%

♦ Often exchangeable, e.g. Suez / Fortis,FT / STM

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Modelling a CB

♦ Maturity

♦ Issue price

♦ Coupon

♦ Redemption price

♦ Discount rate� interest rates

� credit spread

♦ Assumed volatility

♦ Dividend forecasts

♦ Stock price

♦ Conversion premium / price

♦ Call features

Inputs for bond value Inputs for option value

How to value prospectus risk / screws?

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CB valuation�outputs

♦ Premium

� % difference between CB price and parity

♦ Bond value

� Discounted bond cash flows ie ignores equity option

♦ Yield-to-maturity

� Rate of return of bond cashflows

♦ Theoretical value

� What CB is �worth� if inputs and model hold true

♦ Delta

� Indicates equity short hedge ratio

♦ Implied volatility

� Measure of �cost� of equity option

�Simpler� outputs Model outputs

�Cheap� and �Rich�are a matter of opinion � thus making a market

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Implied volatility

♦ Most inputs for pricing are straightforward� e.g. coupon, premium

♦ Some require some estimation� dividends

� credit spread

♦ But the most disputed input is volatility� discount to historic volatility

� volatility levels of comparable issues

♦ Once volatility is input, model calculates theoretical value (TV) of CB

♦ Because inputs are so subjective market convention is to use implied volatility

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Implied volatility

♦ With all other variables fixed, what input volatility gives theoretical value equal to issue price?

♦ With input vol of 25, TV = 102.6

♦ Assume Tau = 0.65

♦ Implied volatility = 25 �

Implied volatility

102.6 � 100.00.65

= 21.0

For outstanding issues, implied volatility relates to current trading price

Worked example

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Bond floor�worked examples

♦ Discount rate 6%, CB coupon 4%, 5-year maturity

♦ What is bond value?

4(1.06)

+ 4(1.06)2

+ 4(1.06)3

+ 4(1.06)4

+ 104(1.06)5

= 91.57

Worked example 1

♦ Discount rate 7%, 3-year maturity

♦ What is coupon needed to get bond value of 90?

c(1.07)

+ c(1.07)2

+ 100+c(1.07)3

= 90

Worked example 2

c = 3.19% (or approximately 3.25%)

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Issuer call feature

♦ 5 year convertible with call after three years

♦ Issuer can redeem bonds early in 30 days� time (at 100%)

♦ If parity above 100% investors would rather convert

♦ Soft call:� bonds only callable if parity above e.g. 130%

� helps issuers extract better value from investors

� 30 day share price risk means some cushion needed anyway

Powerful tool for issuers to force conversion

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Rules of thumb�call feature

♦ 5-year maturity with NC3 (130%) most common today

♦ Why have a trigger?� improves other terms versus unconditional call

� pragmatic �cushion� required to exercise unconditional call over30 days, so might as well have trigger

♦ Call timing� investors are wary of calls less than three years

� investors could lose a lot of option value if exercised

� but they may be key to meeting issuer�s needs

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Rules of thumb�premium redemption

♦ Yield to maturity 50bp more than conventional

♦ Premium unchanged

♦ Why?� premium redemption less likely to convert

� investor needs compensation for lower option value

� investor needs compensation for lost coupon income

Zero coupon

♦ May need even more yield

♦ May need lower premium

♦ Dividend income loss effects more pronounced

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Rules of thumb�puts

♦ One-time option

♦ Allows investor to get money back before maturity

♦ Effectively shortens maturity

♦ Investors value to put date not maturity

♦ Smoke and mirrors tactic by banks

� give issuer and investor maturities they want

� long dated zero coupon deals issued at a discount

� e.g. Roche �US$3 billion� deal only raised US$1.2 billion

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A CB is not a bond plus warrants

♦ Can a CB be valued as a bond plus a call option?

♦ Whilst similar, the two are not the same� investor bases different� �usability� i.e. floating strike option� warrants not callable

♦ CB pricing software more complex than Black-Scholes

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The Greeks

♦ Change in theoretical value for +1% change in stock

♦ Dictates stock to sell short to neutralise equity risk

♦ Typically 50�70% at issue

Delta

♦ Change in Delta for +1% change in stock

♦ Positive number�Delta increases as stock risesGamma

♦ Change in theoretical value for +1% change in volatility

♦ Typically around 0.70

♦ e.g. 20% vol = 101.4% TV21% vol = 102.1% TV

Tau / Vega

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UBS Limited1 Finsbury AvenueLondon, EC2M 2PP

Tel: +44-20-7567 8000

www.ubs.com

UBS Investment Bank is a business group of UBS AG UBS Limited is a subsidiary of UBS AG.

Contact information

Head of Convertibles MarketingTel: +44-20-7568 2282email: martin.haycock@ubs.com

Web pages: www.ubs.com

Bloomberg: UCBR,UCBI,UCBP

Reuters: CBMENU

Martin Haycock

3080381l.ppt 26

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