The Global Capital Market Prof. Ian Giddy New York University

The International Capital Market International bank financing Eurobonds, foreign bonds and global bonds “A Day in the Life” The secondary market The primary market Structured financing

Short-Term Financing: Evolution DIRECT COMMERCIAL PAPER ENHANCED BANK L/Cs INTERMEDIATED BANK LOANS

Alternative Sources of Short-Term Financing DEBT EQUITY Alternative Sources of Short-Term Financing DOMESTIC LOANS

Alternative Sources of Short-Term Financing DEBT EQUITY Alternative Sources of Short-Term Financing DOMESTIC LOANS EUROMARKET LOANS

Alternative Sources of Short-Term Financing DEBT EQUITY Alternative Sources of Short-Term Financing DOMESTIC LOANS EUROMARKET LOANS SYNDICATED EUROCREDITS

Alternative Sources of Short-Term Financing DEBT EQUITY Alternative Sources of Short-Term Financing DOMESTIC LOANS EUROMARKET LOANS SYNDICATED EUROCREDITS NOTE ISSUANCE FACILITIES

Alternative Sources of Short-Term Financing DEBT EQUITY Alternative Sources of Short-Term Financing DOMESTIC LOANS EUROMARKET LOANS SYNDICATED EUROCREDITS NOTE ISSUANCE FACILITIES EUROCOMMERCIAL PAPER

A Revolver RUF Structure: Arranger Underwriting banks Tender panel Agent

RUF Stuff Need lots of money fast? Arrange syndicated Have trouble accessing CP market? Arrange syndicated credit YES Confident of always being able to access the short-term market? Arrange Euronote program YES Arrange RUF or MOF: Underwritten Euronote program Need funds? Don’t issue paper NO Cannot sell paper at L+10bp? Borrow from banks YES Issue Euronotes or other paper

Alternative Sources of Long-Term Financing Bank credits - syndicated lending and facilities Bonds Domestic, foreign, Euro Public, private Structured, such as principle-indexed notes Medium-term notes Asset-backed financing and leasing Project financing DEBT EQUITY

Long-Term Financing: Evolution DIRECT PUBLIC BONDS ENHANCED BANK-GUARANTEED BONDS INTERMEDIATED BANK TERM LOANS

The Global Bond Market Domestic bonds Foreign bond Eurobonds (Issued within country of currency, by non-resident issuers) Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) Global Bonds (Issued in the domestic and the Eurobond markets simultaneously)

The Global Bond Market Domestic bonds Foreign bond Eurobonds (Issued within country of currency, by non-resident issuers) Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) Global Bonds (Issued in the domestic and the Eurobond markets simultaneously)

International Bond Markets are Linked Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps Domestic US Domestic BOND Japanese MARKETS - Gov't WITHIN - Corporate - Gov't COUNTRY - Corporate OF Foreign CURRENCY Bonds Foreign "Yankee" Bonds "Samurai" Currency Swaps BOND MARKETS OUTSIDE Eurodollar Euroyen COUNTRY Bond Market Bond Market OF CURRENCY Long-dated Forward Exchange

Foreign Bonds A foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower The three largest foreign bond markets are Japan, Switzerland, and the U.S., representing issuance of about $40 billion in bonds annually

Private Placements and Rule 144A The private placement exemption from registration and disclosure is extended to Eurobonds as long as the U.S. investors meet the following requirements: They are large and sophisticated There are only a few investors They have access to information and analysis similar to that which would ordinarily be contained in a registered offering prospectus They are capable of sustaining the risk of losses, and They intend to purchase the bonds for their own investment portfolios, and not for resale.

Characteristics of Eurobonds Issued outside country of currency Not subject to domestic registration or disclosure requirements In most cases take form of private placements Placed through syndicates in many countries who sell principally to nonresidents Bonds are structured so as to be free of withholding tax Bearer form But... Eurobonds usually influenced de facto by government and banks of country of currency

Global Bonds

Key Dates in the Issuance of a Eurobond

Key Players in the Issuance of a Eurobond MANAGERS SELLING GROUP UNDER- WRITERS

Who Gets What Fees, percent Fees, amount Net price Price paid by investor (in theory) 101.50 Price paid by member of selling group 60% 0.90 100.60 Price paid by member of underwriting group 60%+20% 0.90+0.30 100.30 Price paid by managers (plus "praecipium" paid to lead manager) 60%+20%+20% 0.90+0.30+0.30 100.00

Pricing Eurobonds in the Secondary Market What "spread to Treasury" should it yield relative to similar bonds--credit risk, duration and liquidity--trading in the secondary market? Use the desired yield to maturity to find its present value at the next coupon date. Find today's present value of that amount, including the coupon to be paid Actual price is quoted as "clean price," meaning not counting accrued interest

The Eurobond Secondary Market

Eurobond Secondary Market Quotations Examine the straight bonds listed What determines the yields? The bid-offer spreads? Does this differ by currency? Can you explain the pricing of the floating rate notes?

A Day in the Life of the Eurobond Market Examine the deals Why were each done in that particular form? What determines the pricing? Can you break the hybrids into their component parts?

A Day in the Life...

Asset-Backed Eurobonds Legal risk: Legal structure: sale of assets to separate subsidiary that issued ABS. Default risk: Overcollateralization dictated by rating agencies Replenishment of collateral Third-party garantees. Prepayment risk: Early redemption caused by “spread trigger”.

Equity-Linked Eurobonds Eurobonds with warrants Marui Convertible Eurobonds Battle Mountaingold Index-linked Eurobonds Bank of Montreal

Equity Financing Choices Conver-tibles Warrants Equity ADRs Common

Values and Market Premium Conversion Value Straight Bond Value V a l u e o f C n v r t i b B d ($) 0 Market Value Market Premium Price Per Share of Common Stock

Values and Warrant Premium 1994, HarperCollins Publishers Copyright Values and Warrant Premium V a l u e o f W r n t ($) Market Value Market Premium Theoretical Value Price Per Share of Common Stock ($)

“Hybrid” Features of A Bond Issue Conversion Feature - compound option Warrants - two instruments Index-linked bonds Call Feature Bond value = straight bond value - call value These are all example of hybrid bonds and should be priced by decomposition

International Equity Markets and Portfolio Diversification No well-accepted international version of the capital asset pricing model. The benefits of diversification globally are empirical issues. The empirical case for international diversification has two components. Establish the riskiness of foreign investment, and the extent to which combining a foreign with a domestic portfolio reduces risk. Even if it reduces risk, does foreign investment also reduce expected return? Then what we have to do is make sure we understand how international diversification is best achieved.

Portfolio Return and Risk where wi are the weights of each asset in the portfolio. (Expected return is simply the weighted sum of the individual asset returns.) Portfolio variance: When i = j, the term wiwjFiFjDij becomes wi2Fi2.

The Minimum-Variance Frontier of Risky Assets Efficient frontier Individual assets Global minimum-variance portfolio

Optimal Overall Portfolio Indifference curve CAL Opportunity set P Optimal complete portfolio

The Global Efficient Frontier

Evidence Suggests Index Funds are Not for the International Investor For the international investor the capitalization-weighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM. Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk-free asset acceptable to both. Studies confirm these propositions

International Portfolio Optimization: Passive vs Active Portfolios (Let the proportions of all possible assets vary until the optimal proportions are found.) The results of letting the computer find the best proportions for various levels of return:

Obstacles to International Investment Might Include: Information barriers. Political and capital control risks. Foreign exchange risks. Restrictions on foreign investment and control. Taxation. Higher costs.

Conclusion: The international equity market is imperfect Hence there may be advantages to international equity issuance How should companies achieve this?

Financing with Structured Securities Prof. Ian Giddy New York University

Principles of Innovation Through Financial Engineering 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.

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-.10 Is not too concerned about specific timing of issue, amount or maturity Is willing to consider hybrid structures.

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

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.

The Deal 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

The Deal / 2 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.

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 DEUTSCHE SCOTTISH LIFE CSFB

The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB Deutsche sells 3-year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE CSFB

The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB Deutsche sells 3-year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE 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 CSFB

The Deal in Detail SCOTTISH DEUTSCHE LIFE CSFB Deutsche sells 3-year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE 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) CSFB

The Deal in Detail DEUTSCHE SCOTTISH LIFE CSFB CLIENT Deutsche sells 3-year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE 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) CSFB CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise CLIENT

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.

Motivations for Issuing Hybrids 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?)

The International Capital Market International bank financing Eurobonds, foreign bonds and global bonds “A Day in the Life” The secondary market The primary market Structured financing

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