Prof. Ian Giddy New York University Structured Finance: Fixed Income

Copyright ©2002 Ian H. Giddy Structured Finance 2 Structured Finance l Asset-backed securitization l Corporate financial restructuring l Structured financing techniques

Copyright ©2002 Ian H. Giddy Structured Finance 3 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?)

Copyright ©2002 Ian H. Giddy Structured Finance 4 “Hybrid” Features of A Bond Issue l Example: callable bonds l Call Feature  Call price - par value = call premium  Call feature can be valued independently  The call feature is advantageous to the issuer, but it comes at a price

Copyright ©2002 Ian H. Giddy Structured Finance 5 Treasury Bonds Source: bondsonline.com (May )

Copyright ©2002 Ian H. Giddy Structured Finance 6 Treasury Bonds

Copyright ©2002 Ian H. Giddy Structured Finance 7 Treasury Bond Options

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Copyright ©2002 Ian H. Giddy Structured Finance 9 Assignment Guernsey

Copyright ©2002 Ian H. Giddy Structured Finance 10 Callable Bonds and Hybrid Securities General Principle: Callable bonds and other hybrid securities are simple or complex combinations of other individual securities General Method: 1 Identify investor’s or issuer’s needs, constraints and views. 2 Break up bond into components and find value of the total. 3 Compare this with realistic alternatives. Is this the best way to satisfy investor’s and issuer’s needs and views?

Copyright ©2002 Ian H. Giddy Structured Finance 11 A Call to Guernsey Which bond, priced at par, offers the best value? l A 4-year Sony Eurodollar bond paying 8.50%, callable at in two years. l A 4-year BASF Eurodollar bond paying 8.48%, callable at in three years. l A 4-year SNCF noncallable Eurodollar bond, paying 8.44%.

Copyright ©2002 Ian H. Giddy Structured Finance 12 Guernsey: Rates March 24, 1996 U.S. TREASURY YIELD CURVE AA CORPORATE YIELDS VOLATILITY OF TREASURY YIELD 3 MONTHS 1 YEAR 2 YEARS 3 YEARS 4 YEARS 5 YEARS 10 YEARS 30 YEARS % 9.6% 10% 11.2% 9.9% 9.7%

Copyright ©2002 Ian H. Giddy Structured Finance 13 A Call to Guernsey n Install the disk files into a directory called AKA n Run AKA n Use Valuation/Callable bonds n Put in the data; enter 999 for years where there is no call option.

Copyright ©2002 Ian H. Giddy Structured Finance 14 Guernsey: Results

Copyright ©2002 Ian H. Giddy Structured Finance 15 Guernsey: Results

Copyright ©2002 Ian H. Giddy Structured Finance 16 Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at ? Ans: 6% 4% 5% Forward Interest Rates

Copyright ©2002 Ian H. Giddy Structured Finance 17 I can buy a 2-year note or buy a 1-year note and reinvest it at some "forward" rate f: (1+y 2 ) 2 =(1+y 1 )(1+f) Find f! Calculating Implied Forward Rates

Copyright ©2002 Ian H. Giddy Structured Finance 18 Borrow for 6 months at 5% FRA Mechanics Invest for 3 months at 4% Lock in cost at 6% SET RATE AT 6% IF LIBOR > 6%, B PAYS H IF LIBOR < 6%, H PAYS B HOW MUCH? PV[(LIBOR-6%)/4]

Copyright ©2002 Ian H. Giddy Structured Finance 19 FRA Valuation SET RATE AT 6% IF LIBOR > 6%, B PAYS H IF LIBOR < 6%, H PAYS B HOW MUCH? PV[(LIBOR-6%)/4] l How does the FRA’s value change over time? l It depends on what happens to Libor.

Copyright ©2002 Ian H. Giddy Structured Finance 20 Swaps: Mechanics and Valuation GE Chase Fixed 8% Floating USD Libor Periodic exchanges of interest payments are made during the life of the swap. (The principal amount is not exchanged.)

Copyright ©2002 Ian H. Giddy Structured Finance 21 Interest Rate Swap: An Extended FRA The typical interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time. Effectively, it involves paying the difference between a fixed rate and Libor, like a FRA: GE Chase 8% Fixed 3-mo Libor, floating 8%-Libor

Copyright ©2002 Ian H. Giddy Structured Finance 22 Swaps GE Chase 8% Fixed 3-mo Libor, floating Ongoing short-term funding

Copyright ©2002 Ian H. Giddy Structured Finance 23 Interest Rate Swap Valuation l How does a swap’s value change over time? l It depends on what happens to the fixed rate (the “swap rate”) GE Chase 8% Fixed 3-mo Libor, floating

Copyright ©2002 Ian H. Giddy Structured Finance 24 l Valuation l Off-market swaps l Cancellation l Counterparty exposure l Hedging swap positions Swaps: Applications of Valuation BONDBOND FRN Labatt’s RBC Fixed 9% Floating Libor

Copyright ©2002 Ian H. Giddy Structured Finance 25 Swaptions Swaption is an option on a swap:  The right to enter into a new swap at a given date in the future, or  The right to cancel an existing swap, or  The right to extend an existing swap.

Copyright ©2002 Ian H. Giddy Structured Finance 26 Labatt’s Bank Fixed USD 9% Floating USD Libor s.a. Swap Valuation and Swaptions The value of a swap equals the "net worth" of the swap cash flows expressed as a balance sheet

Copyright ©2002 Ian H. Giddy Structured Finance 27 Swap Valuation and Swaptions

Copyright ©2002 Ian H. Giddy Structured Finance 28 From Swap to Swaption l What if Labatt's had the right to cancel this swap after 3 years? l To Labatt's, this would be exactly like a callable bond. In other words, swaptions are substitutes for callable bonds l Hence swaptions are priced like options on fixed rate bonds.

Copyright ©2002 Ian H. Giddy Structured Finance 29 Swaption Quotations

Copyright ©2002 Ian H. Giddy Structured Finance 30 Swaption Symmetry l Put-call parity says: “A put option plus a long position in the underlying is the same as a call option” l The bank is “long the underlying swap” (receiving fixed). If it has the right to cancel the swap (pay fixed 9%) after 5 years, this combination is the same as the right to receive fixed 9% from years 5 to 7. Labatt’s Bank Fixed 9% Floating Libor A 7-YEAR SWAP

Copyright ©2002 Ian H. Giddy Structured Finance 31 Using Options Technology in Investment and Financing Caps, collars, swaps, swaptions can be used in a number of ways to enhance financing:  To hedge an asset. Eg floating rate borrowing + cap to hedge capped consumer loans.  With a debt issue, to "strip" a feature off the bond. Eg issue callable bond, sell a swaption to a bank.  To take a view on the direction or volatility of interest rates. Eg. sell a swaption.

Copyright ©2002 Ian H. Giddy Structured Finance 32 Caps and Floors An interest-rate collar involves buying a cap and selling a floor: RATE TIME 5% 7%

Copyright ©2002 Ian H. Giddy Structured Finance 33 Caps, Floors and Collars l Cap: Agreement to compensate buyer when interest rate exceeds a specified ceiling. l Floor: Agreement to compensate buyer when interest rate falls below a specified floor. l Collar: A simultaneous purchase of a cap and sale of a floor. Net cost is the price of the cap less the value of the floor. Example:  If LIBOR > 12% cap, bank pays borrower the difference  If LIBOR < 4% floor, borrower pays bank the difference l Swaption: Option on a swap.

Copyright ©2002 Ian H. Giddy Structured Finance 34 Decomposing Option Products: Example of an Interest Rate Cap 11% CAP LIBOR

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Copyright ©2002 Ian H. Giddy Structured Finance 37 Cap Pricing Model Cap/Floor Rate 12 Period in days 91 Days to next coupon 30 Yield volatility 21.5

Copyright ©2002 Ian H. Giddy Structured Finance 38 Factors Influencing Cap Prices l Length l Steepness of yield curve l Volatility Yield Curve (Zero rates) Volatility Curve Forward Rates Cap

Copyright ©2002 Ian H. Giddy Structured Finance 39 Medium-Term Notes: Anatomy of a Deal

Copyright ©2002 Ian H. Giddy Structured Finance 40 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-.10  Is not too concerned about specific timing of issue, amount or maturity  Is willing to consider hybrid structures.

Copyright ©2002 Ian H. Giddy Structured Finance 41 Anatomy of a Deal Investor:  Has distinctive preference for high grade investments  Looking for investments that will improve portfolio returns relative to relevant indexes  Invests in both floating rate and fixed rate sterling and dollar securities  Can buy options to hedge portfolio but cannot sell options

Copyright ©2002 Ian H. Giddy Structured Finance 42 Anatomy of a Deal Intermediary:  Has experience and technical and legal background in structure finance  Has active swap and option trading and positioning capabilities  Has clients looking for caps and other forms of interest rate protection.

Copyright ©2002 Ian H. Giddy Structured Finance 43 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

Copyright ©2002 Ian H. Giddy Structured Finance 44 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.

Copyright ©2002 Ian H. Giddy Structured Finance 45 The Issue l Issuer: Deutsche Bank AG l Amount: US$ 40 Million l Coupon: First three years: semi-annual LIBOR + 3/8% p.a., paid semi-annually Last 5 years: 8.35% l Price: 100 l Maturity: February 10, 2000 l Call: Issuer may redeem the notes in full at par on February 10, 1995 l Fees: 30 bp l Arranger: Credit Swiss First Boston

Copyright ©2002 Ian H. Giddy Structured Finance 46 The Parties in the Deal SCOTTISH LIFE CSFB DEUTSCHE

Copyright ©2002 Ian H. Giddy Structured Finance 47 The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8%

Copyright ©2002 Ian H. Giddy Structured Finance 48 The Deal in Detail SCOTTISH LIFE CSFB 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

Copyright ©2002 Ian H. Giddy Structured Finance 49 The Deal in Detail SCOTTISH LIFE CSFB 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)

Copyright ©2002 Ian H. Giddy Structured Finance 50 The Deal in Detail SCOTTISH LIFE CSFB 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

Copyright ©2002 Ian H. Giddy Structured Finance 51 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.

Copyright ©2002 Ian H. Giddy Structured Finance 52 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.

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Copyright ©2002 Ian H. Giddy Structured Finance 57 Contact Info Ian H. Giddy NYU Stern School of Business Tel ; Fax