1. Prof. Ian Giddy New York University
DBS Bank
Hybrid Securities
Prof. Ian Giddy
New York University

2. What determines the optimal mix of debt and equity for a company?
The Agenda
What determines the optimal mix of debt and equity for a company?
How does altering the mix of debt and equity affect the value of a company?
What is the right kind of debt for a company?
These are the basic questions that we will try to answer in this part of the discussion.

3. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING
RISK MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT
EQUITY
M&A
TOOLS

4. Debt?
Equity?
What kind?

5. When Debt and Equity are Not Enough
Assets
Liabilities
Value
of future
cash flows
Claims on
the cash flows

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

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

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

9. Hybrid Financial Instruments
Prof. Ian Giddy
New York University

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

11. 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?

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

13. A Day in the Life...

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

15. Warrants Market Value Market Premium Theoretical Value V a l u e o f W
($)
Market
Value
Market Premium
Theoretical
Value
Price Per Share of Common Stock ($)

16. Convertibles Conversion Value Market Value Market Premium 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

17. Nikkei-Linked
PRINCIPAL
REPAYMENT
19,000
28,000

18. Bank of Montreal Nikkei-Linked Note
Bankers Trust
Bank of Montreal
Nippon Credit
Japanese insurance companies
US pension fund with Japan portfolio

19. Structured Notes 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.

20. Medium-Term Notes: Anatomy of a Deal

21. 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.

22. 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

23. 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.

24. 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

25. 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.

26. 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

27. The Parties in the Deal
DEUTSCHE
SCOTTISH
LIFE
CSFB

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

29. 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

30. 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

31. 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

32. 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.

33. Option Pricing Time value depends on Time Volatility
Distance from the strike price
Option Price
Option Price
= Intrinsic value + Time value
Underlying
Price
94.5
94.75

34. Option Pricing Model 1.8 1.6 1.4 1.2 1 CALL OPTION PRICE 0.8 0.6 0.4
0.2 93 94 95 96
FUTURES PRICE

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

36. Black-Scholes Option Valuation
Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 - (T1/2)
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.

37. Breaking Down a Convertible: Unisys
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%.
What’s the straight bond component worth?
What’s the convertible option worth?

38. Breaking Down a Convertible: Unisys

39. Motivations for Issuing Hybrid 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?)

40. Economics of Financial Innovation
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.

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

42. Why Innovations Fail
The rationale evaporates
It’s too costly
It’s New Coke

46. Case Study: Banpu Convertible
How did this work?
Why did Banpu use this technique?
Why did investors buy it?

47. Banpu Convertible
Huh?

48. Thai Time
1994
1997
1999
2004

49. www.giddy.org Ian Giddy NYU Stern School of Business
Tel ; Fax