1. Presented by Robert M. Lichten, Jr.
Deal Contingent Transactions The derivative product that helped fuel the M&A Boom
Presented by
Robert M. Lichten, Jr.

2. Robert Lichten - Bio
Robert M. Lichten, Jr. has worked at JP Morgan and its predecessor firms for more than 15 years. Most recently, he was Global Head of Sales and Trading for Foreign Exchange and the head of US Derivative Origination. Mr. Lichten was also responsible for emerging market , equity as well as commodity derivatives in the past. The most recent portfolio of business was in excess of $2 billion of revenue and included employees all over the world. Mr. Lichten is currently on sabbatical from JP Morgan. Mr. Lichten has an undergraduate degree in math and economics from Union College in Schenectady, NY and a MBA in finance from NYU where he graduated with honors. Mr. Lichten and his wife Susan, have four children and live in Westchester, NY.

3. Discussion Topics What are deal contingent transactions (DCT)?
Why do banks/customers enter into the transactions?
What are the risks / rewards from the bank’s and the customer’s perspective?
Q&A

4. What are DCTs?
A contractual agreement to enter into a derivative contract that is contingent upon an underlying event occurring.
If the contingent event occurs, the derivative is active, if not, the derivative is not active and usually the customer walks away from the underlying transaction at no cost.
Trillions of dollars of DCTs have been executed on fixed income, FX, credit, commodity and equity underlyings producing enormous risks and potential rewards for financial intermediaries.
The transactions are most commonly used in M&A (i.e. contingent if the deal goes through or not), however the contingency trigger can be set at anything.

5. Why do customers use them?
Typically cheaper than the break even of a plain vanilla option.
No cost, if the underlying deal does not occur - although the deals can be structured with a “deductible” to lower the cost.
Can provide the customer with a competitive advantage in a bidding situation.
Gives the customer a hedge for an unknown and potentially volatile cost during the closing process.

6. Why do banks offer them if a perfect hedge does not exist?
Provides better risk/return than risk arbitrage – banks typically only want to enter into transactions where there is a high probability the underlying deal will occur.
In order for the banks to lose money, the underlying deal does not happen plus the bank’s hedges have to move out of the money.
Banks can set up market hedges to quantify a worst case scenario and can syndicate a portion of the risk to other banks/hedge funds.
Contingent triggers are set to avoid moral hazard from the customer’s perspective.
Typically done with public companies.

7. FX Example
A US private equity firm was competing to purchase an asset in Europe for a net 5 billion Euros – capital markets in Europe could only provide Euro financing for a limited amount of Euros.
The US private equity firm was competing against other US private equity firms and European private equity firms that did not have fx risk.

8. FX Example – Underlying Assumptions
Spot Rate = 1.18 dollars per Euro
Forward Rate = 1.21
ATMF Option Premium = 150mm USD (3 cents)
Zero Cost Collar = 1.17/1.2450
Deal Contingent Forward (DCF) = 1.235
Deal Contingent Option = 180mm USD
Notional = 5 bln Euros
Closing Date = 6 months
*1 standard deviation from spot = 1.27 (450mm)
*2 standard deviations from spot = 1.36 (900mm USD)
*Assumes 10% volatility

9. FX Example
The customer entered into a DCF at subject to regulatory and shareholder contingent triggers.
If the contingent event is delayed, the cost for the bank to roll its hedges is specified within the contract subject to a maximum cost per day*.
Client ends up winning the bid because the Euro appreciated substantially, other counterparties did not utilize the same product and there were other strategic reasons.
*cannot be hedged perfectly

10. FX Example – Bank’s Perspective
The bank is exposed if the deal doesn’t happen and the Euro declines in value versus the dollar.
The bank will typically purchase low delta or “wing” options on the full amount, flooring its maximum loss – i.e. enter into a forward to buy euros at 1.21 and purchase 1.18 Euro puts. Banks will also enter into forwards for a portion of the notional with wing options and purchase atmf options to give itself more up-side, if the deal goes through and the Euro depreciates.

11. FX Example – Bank’s Perspective
Assume probability of closing is 90% per the advisors that work in the bank and the customer has a dcf
The bank enters into a forward at 1.21 and purchases 1.18 Euro puts for .5 cents
If the deal doesn’t happen and the Euro is greater than 1.215, the bank will be in the money.
If the deal happens, the bank will earn 2 cents or 100MM USD.
If the deal doesn’t happen and the Euro is less than 1.21, the bank’s maximum loss is 3.5 cents or 175mm USD.
Expected value is 90mm USD (90% of 100mm) happening and 17.5mm not to happen.
The most important element is the probability of closing.
Certain banks began doing deals based upon much lower probabilities of closure.

12. FX Example – Bank’s Perspective
Banks set maximum loss levels and want a portfolio of transactions to balance out its risks (i.e find customers to sell Euros).
Banks will sell away/hedge anything in excess of its risk limits, regardless of the probability of the deal(s) closing. The same risk management discipline is applied to any trading group.

13. Cross Currency Swap Example - Duration & Credit Risk
Corporate is trying to purchase a US Company that generates most of its assets in Mexican Pesos.
Deal can only be financed in dollars (500MM, 10 Year) so the company decides to enter into a deal contingent cross currency swap.
Fixed USD
Corporate
Bank
Fixed Pesos
Fixed USD
Initial Exchange: Corporate receives MXN and pays USDs
Final Exchange: Corporate pays MXN and receives USDs

14. Cross Currency Swap Example
Assumptions:
10 year USD Swap: 5%
10 year UST: 4.5%
10 year peso /peso rate: 8.00%
TIIE/LIBOR Basis = 8 bps
Credit Spread: 4%
Contingent Period: 6 Months
Initial and Final Exchange: 11.00
( Current Spot FX Rate)
LIBOR
5.00%
8.50% USD
LIBOR
Corporate
Bank
TIIE
12.05% MXN *
8.50% USD
(T +4%)
TIIE
8.00%
* Does not include cost of credit or contingent costs

15. Cross Currency Swap Example – Hedges from the Bank’s Perspective
If the deal does not happen, everything else equal, the bank will lose if the dollar declines versus the Peso - i.e. declines from 11 to 10.
If the deal does not happen, everything else equal, the bank will lose if peso rates decline relative to dollar rates.
Banks can make correlation assumptions or purchase an option capping its worst case mark to market, effectively passing on the correlation risk to another bank.
8.50% USD
Corporate
Bank
Fixed Pesos
8.50% USD
(T + 4%)
Initial Exchange: Corporate receives MXN and pays USDs
Final Exchange: Corporate pays MXN and receives USDs

16. Cross Currency Swap - Pricing in the Credit Risk
2 Standard Deviation Movement = $360MM
Loan Equivalent Risk = $90MM*
Credit Spread = 4.00%
Earn 4% per annum on 90MM Loan Equivalent = $28MM PV or 6.32bps per annum in pesos.
The bank needs to earn this amount to be indifferent between investing in the underlying credit or entering into the derivative.
If credit spreads increase over the contingent period, the bank will face additional costs.
For example, each 1% movement is equal to $7MM in present value terms.
This credit risk cannot be hedged perfectly and banks usually make conservative assumptions as it does to hedge the roll risk.
*Loan Equivalent = 2 Standard Deviation Movement divided by 4 (take 2 standard deviations and divide it through by .5 because there is 50% chance of the trade going in the money for the bank.

17. Cross Currency Swap Example - Duration & Credit Risk
Increasing duration adds another potentially large cost that cannot be hedged perfectly.
Most banks did and still do not price in this component properly.
If the deal does happen and the credit risk is not priced in properly, selling down the credit risk could be very difficult.
Fixed USD
Corporate
Bank
Fixed Pesos
Fixed USD
Initial Exchange: Corporate receives MXN and pays USDs
Final Exchange: Corporate pays MXN and receives USDs

18. Conclusions and Q&A
The most important factor is the probability of closing.
Provides clients with known costs in a competitive bid situation.
Gives the banks mostly quantifiable risks that cannot always be hedged perfectly, but if done on a portfolio basis with aggregate risk limits can provide an attractive line of business.
Definitely helped fuel the recent M&A boom and was most frequently used by Private Equity firms.