prof. ian giddy new york university hybrid securities sim/nyu the job of the cfo

Prof. Ian GiddyNew York University

Hybrid Securities

SIM/NYUThe Job of the CFO

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

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 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?


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



Value

of future

cash flows

Value

of future

cash flows

Contractual int. & principal

No upside

Senior claims

Control via restrictions


No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims

Voting control rights

Residual payments

Upside and downside

Residual claims


Equity



Value

of future

cash flows

Value

of future

cash flows


No upside

Senior claims



No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims


Residual payments

Upside and downside

Residual claims


Equity

What if...

Claims

are inadequate?

Returns

are inadequate?



Value

of future

cash flows

Value

of future

cash flows


No upside

Senior claims



No upside

Senior claims


Assets Liabilities

Debt

Residual payments

Upside and downside

Residual claims


Residual payments

Upside and downside

Residual claims


Equity

Alternatives

Collateralized Asset-securitized Project financing

Preferred Warrants Convertible


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

hedge

Debt or

equity are

Not good enough


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 .


Equity-Linked Eurobonds

Eurobonds with warrantsMarui

Convertible EurobondsBattle Mountaingold

Index-linked EurobondsBank of Montreal


Warrants

TheoreticalValue

Market ValueMarket Premium

Value

of

Warrant

($)

0Price Per Share of Common Stock ($)


Convertibles

ConversionValue

StraightBond Value

Market ValueMarket Premium

Value

of

Convertible

Bond

($) 0

Price Per Share of Common Stock


Nikkei-Linked

28,00019,000

PRINCIPAL

REPAYMENT


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.


Carps III

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

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

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

performance of the Frank Russell Japan Equity Fund.

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

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

delivering a consistently above-market return with reduced risks.


Carps III

Client’s objectives The “Guaranteed Minimum Return” product 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: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-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


The Parties in the Deal

SCOTTISH

LIFE

CSFB

DEUTSCHE


The Deal in Detail

SCOTTISH

LIFE

CSFB

DEUTSCHE

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


The Deal in Detail

SCOTTISH

LIFE

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

SCOTTISH

LIFE

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

SCOTTISH

LIFE

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: 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

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


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 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.


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$

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

Huh?


Thai Time

1994 1997 1999 2004

Prof. Ian GiddyNew York University

Leveraged Finance


M&A and Leverage

Leveraged buyout?

Company has

unused debt

capacity Leveraged

recapitalization?

Takeover?


Typical LBO Sequence

Company gets bloated or slack and stock price falls

LBO offer made

LBO completed

RestructuringEfficienciesDivestiture

sFinancial

? years 3-9 months 5-7 years

IPO or sale of company


John M Case LBO

John Case,

owner

Managers,

buyersCompany

$20 million

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


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

Cash $5762 Current Liab $1266Other current 3236 Bank loan 6000Fixed & other 2184 Case loan 4000

Good will 10084 Plug figure 9500

Managers’ equity

500

Total 21,266 Total 21,266


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%

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 Giddy

NYU Stern School of Business

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

[email protected]

http://www.giddy.org

prof. ian giddy new york university hybrid securities sim/nyu the job of the cfo

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