DBS Bank Hybrid Securities Prof Ian Giddy New

DBS Bank Hybrid Securities Prof. Ian Giddy New York University

The Agenda 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? l Copyright © 2000 Ian H. Giddy Hybrid Securities 2

Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING PORTFOLIO CAPITAL M&A Copyright © 2000 Ian

Debt? Equity? What kind?

When Debt and Equity are Not Enough Assets Value of future cash flows Copyright

When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 2000 Ian H. Giddy Hybrid Securities 6

When Debt and Equity are Not Enough Assets Liabilities Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 2000 Ian H. Giddy What if. . . Claims are inadequate? Returns are inadequate? Hybrid Securities 7

When Debt and Equity are Not Enough Assets Liabilities Alternatives n Debt Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Equity Residual payments Upside and downside Residual claims Voting control rights Copyright © 2000 Ian H. Giddy n n n Collateralized Asset-securitized Project financing Preferred Warrants Convertible Hybrid Securities 8

Hybrid Financial Instruments Prof. Ian Giddy New York University

Managing Hybrid Securities Principles of hybrid instruments l Market imperfections as motives for hybrids l Hybrids in the Eurobond market: l u. Asset-backed securities u. Warrant bonds and convertibles u. Index-linked bonds l Application: callable bonds Copyright © 2000 Ian H. Giddy Hybrid Securities 10

A Day in the Life of the Eurobond Market l Examine the deals u. Why were each done in that particular form? u. What determines the pricing? l Can you break the hybrids into their component parts? Copyright © 2000 Ian H. Giddy Hybrid Securities 11

Why Use a Hybrid? Motivations for Hybrids Linked to business risk Linked to market risk Cannot hedge with derivatives Copyright © 2000 Ian H. Giddy Driven by investor needs Company hedges Company does not hedge Debt or equity are Not good enough Hybrid Securities 12

A Day in the Life. . . Copyright © 2000 Ian H. Giddy Hybrid

Equity-Linked Eurobonds l Eurobonds with warrants u. Marui l Convertible Eurobonds u. Battle l Mountaingold Index-linked Eurobonds u. Bank Copyright © 2000 Ian H. Giddy of Montreal Hybrid Securities 14

Nikkei-Linked PRINCIPAL REPAYMENT 19, 000 Copyright © 2000 Ian H. Giddy 28, 000 Hybrid

Bank of Montreal Nikkei-Linked Note Bankers Trust US pension fund with Japan portfolio Copyright

Structured Notes l l l 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. Copyright © 2000 Ian H. Giddy Hybrid Securities 19

Medium-Term Notes: Anatomy of a Deal Copyright © 2000 Ian H. Giddy Hybrid Securities

Anatomy of a Deal Issuer: u. Looking for large amounts of floating-rate USD and DEM funding for its loan porfolio. u. Wants low-cost funds: target CP-. 10 u. Is not too concerned about specific timing of issue, amount or maturity u. Is willing to consider hybrid structures. Copyright © 2000 Ian H. Giddy Hybrid Securities 21

Anatomy of a Deal Investor: u. Has distinctive preference for high grade investments u. Looking for investments that will improve portfolio returns relative to relevant indexes u. Invests in both floating rate and fixed rate sterling and dollar securities u. Can buy options to hedge portfolio but cannot sell options Copyright © 2000 Ian H. Giddy Hybrid Securities 22

Anatomy of a Deal Intermediary: u. Has experience and technical and legal background in structure finance u. Has active swap and option trading and positioning capabilities u. Has clients looking for caps and other forms of interest rate protection. Copyright © 2000 Ian H. Giddy Hybrid Securities 23

The Deal 1 2 3 4 Initiate medium term note programme for the borrower, allowing for a variety of currencies, maturities and special structures Structuring a MTN in such a way as to meet the investor’s needs and constraints Line up all potential counterparties and negociate numbers acceptable to all sides Upon issuer’s and investor’s approval, place the securities Copyright © 2000 Ian H. Giddy Hybrid Securities 24

The Deal / 2 5 6 For the issuer, swap and strip the issue into the form of funding that he requires 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 25

The Issue l l l l 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 Copyright © 2000 Ian H. Giddy Hybrid Securities 26

The Deal in Detail DEUTSCHE Deutsche sells 3 -year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE For an additional 3/4% p. a. , Deutsche buys three. For 1% p. a. , year put option on 5 -year Deutsche sells CSFB a swaption fixed-rate 8. 35% note to SL in 3 years (the right to pay fixed 8. 35% for 5 years in 3 years) CSFB Copyright © 2000 Ian H. Giddy CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise CLIENT Hybrid Securities 31

What’s Really Going On? Note: l 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 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 32

Option Pricing Option Price Time value depends on n Time n Volatility n Distance from the strike price Option Price = Intrinsic value + Time value 94. 5 94. 75 Underlying Price Copyright © 2000 Ian H. Giddy Hybrid Securities 33

Option Pricing Model 1. 8 1. 6 CALL OPTION PRICE 1. 4 1. 2

Value of Call Option FUTURES PRICE STRIKE INTRINSIC VALUE SHADED AREA: Probability distribution of the log of the futures price on the expiration date for values above the strike. TIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE Copyright © 2000 Ian H. Giddy Hybrid Securities 35

Black-Scholes Option Valuation Co = So. N(d 1) - Xe-r. TN(d 2) d 1 = [ln(So/X) + (r + 2/2)T] / ( T 1/2) d 2 = d 1 - ( T 1/2) where Co = 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 36

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%. u. What’s the straight bond component worth? u. What’s the convertible option worth? Copyright © 2000 Ian H. Giddy Hybrid Securities 37

Breaking Down a Convertible: Unisys Copyright © 2000 Ian H. Giddy Hybrid Securities 38

Motivations for Issuing Hybrid Bonds 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? ) l Copyright © 2000 Ian H. Giddy Hybrid Securities 39

Economics of Financial Innovation l l l 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. Copyright © 2000 Ian H. Giddy Hybrid Securities 40

What Conditions Permit Hybrids to Thrive? l Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond l Tax Distortions Example: Money Market Preferred l Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond l Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs) Copyright © 2000 Ian H. Giddy Hybrid Securities 41