Structured Products Hybrids October 2004 Return to Risk Limited website:

Structured Products & Hybrids Linked Instruments Cross-Market Transactions

Objectives In Structured Products Primary Objective(s) of Using Hybrids Is…?

Objectives In Structured Products Primary Objectives of Using Hybrids Are Typically To… –Lower Hedging Costs –To More Precisely Match A Hedge To Underlying Exposure(s) –Other?

Cross-Market Hedge Instruments What Are The Typical Major Market Exposures (In Terms Of Price Risks) For Most Companies?

Cross-Market Hedge Instrument What Are The Typical Major Market Price Exposures For Most Companies? –Commodities –Currencies –Interest Rates –Other?

Hedge Alternatives How Can These Major Market Price Exposures Be Hedged? –Individually –Jointly –Fully –Partially –Not At All

Attractiveness Of Alternatives What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks? –Aside From Possibly Being Seen As Clever Or Innovative

Attractiveness Of Alternatives What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks? –May Depend Largely On the Correlation Of Past, Expected And Actual Future Price Moves –And The Joint Hedge Structure Crafted –And Corporate Objectives (Financial Results, Cash Flow Requirements, …)

Typical Structure – Total Cost Cap A Derivative Products Dealer Guarantees To An Airline That… –The Total Cost That The Airline Will Incur For Interest Expense and Jet Fuel Purchases Will Not Exceed Some Specified Total Dollar Amount –For A Given Quantity Of Jet Fuel Consumption And A Set Amount Of Floating Rate Funding

Typical Structure – Total Cost Cap The Airline Could Of Course Buy Caps On Jet Fuel Costs and Interest Rates, Separately What Is the Potential Attraction Of The Total Cost Cap Described?

Typical Structure – Total Cost Cap What Is the Potential Attraction Of The Total Cost Cap Described? –Lower Aggregate Premium Costs –Simplicity (For The Buyer, Not The Seller) –Other? Possibly Counter Party Credit Risk Disadvantages? –Illiquidity In Secondary Trading

Typical Structure – Total Cost Cap Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure?

Typical Structure – Total Cost Cap Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure? –Lower Valuation On The Instrument –Due To Lower Probability Of The Hybrid Option Being In The Money

Typical Structure – Total Cost Cap How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions? –Well It Depends…

Typical Structure – Total Cost Cap How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions? –It Depends On… –Correlation Of Prices –Structure Of The Hybrid Cap; Ratio Of Quantities, Seasonal Time Period, Jet Fuel Illiquidity And Hence Quantity Hedged

Typical Structure – Total Cost Cap Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element?

Typical Structure – Total Cost Cap Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element? –Depends On What They View Themselves As Hedging –All Unfavorable Rate Movements –Costs –Cash Flows

Typical Structure – Total Cost Cap Is The Correlation Of Price Moves Between Energy And Interest Rates High?

Typical Structure – Total Cost Cap Is The Correlation Of Price Moves Between Energy And Interest Rates High? –Intuitively One Might Think So –But In Fact For Most Time Periods Historically The Correlation Levels Have Been Rather Low

Another Example – Knock Out I-Rate Caps Popular With Independent Gas Producers A Hybrid, Cross-Market, Structured Product That Focuses On Reducing Interest Rate Hedge Costs By Eliminating Coverage When Cash Flows From Natural Gas Revenues Are Known To Be High

Another Example – Knock Out I-Rate Caps Standard Interest Rate Option (Rate Cap), That Is “Knocked Out” If Gas Prices Rise Above Some Pre-defined Level Interest Rate Cap Premium Is Below Market, But The Holder Loses Coverage If Gas Prices Jump Up –But The Gas Producer May Not Be Concerned About Financing Costs Since They Will Be Generating So Much Revenue On Gas Sales

Other Hybrids Structured Notes Commodity Indexed Bonds Semi-Fixed Or Digital Swaps

Conclusions Structured Products Serve An Important Market Function –Although A Few Are Fluff Or Trickery Can Be Somewhat Complex To Price And Trade