1. Prof. Ian Giddy New York University Hybrid Securities SIM/NYU The Job of the CFO

2. Copyright ©2001 Ian H. Giddy Hybrid Securities 2 giddy.org The Agenda l What determines the optimal mix of debt and equity for a company? l How does altering the mix of debt and equity affect the value of a company? l What is the right kind of debt for a company?

3. Copyright ©2001 Ian H. Giddy Hybrid Securities 3 giddy.org Corporate Finance CORPORATE FINANCE DECISONS CORPORATE FINANCE DECISONS INVESTMENT RISK MGT FINANCING CAPITAL PORTFOLIO M&A DEBTEQUITY TOOLS MEASUREMENT

4. Debt? Equity? What kind? Debt? Equity? What kind?

5. Copyright ©2001 Ian H. Giddy Hybrid Securities 5 giddy.org When Debt and Equity are Not Enough Value of future cash flows Value of future cash flows Claims on the cash flows Claims on the cash flows AssetsLiabilities

6. Copyright ©2001 Ian H. Giddy Hybrid Securities 6 giddy.org When Debt and Equity are Not Enough Value of future cash flows Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity

7. Copyright ©2001 Ian H. Giddy Hybrid Securities 7 giddy.org When Debt and Equity are Not Enough Value of future cash flows Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity What if... Claims are inadequate? Returns are inadequate?

8. Copyright ©2001 Ian H. Giddy Hybrid Securities 8 giddy.org When Debt and Equity are Not Enough Value of future cash flows Value of future cash flows Contractual int. & principal No upside Senior claims Control via restrictions Contractual int. & principal No upside Senior claims Control via restrictions AssetsLiabilities Debt Residual payments Upside and downside Residual claims Voting control rights Residual payments Upside and downside Residual claims Voting control rights Equity Alternatives n Collateralized n Asset-securitized n Project financing n Preferred n Warrants n Convertible

9. Copyright ©2001 Ian H. Giddy Hybrid Securities 9 giddy.org Managing Hybrid Securities l Principles of hybrid instruments l Market imperfections as motives for hybrids l Hybrids in the Eurobond market:  Asset-backed securities  Warrant bonds and convertibles  Index-linked bonds l Application: callable bonds

10. Copyright ©2001 Ian H. Giddy Hybrid Securities 10 giddy.org A Day in the Life of the Eurobond Market l Examine the deals  Why were each done in that particular form?  What determines the pricing? l Can you break the hybrids into their component parts?

11. Copyright ©2001 Ian H. Giddy Hybrid Securities 11 giddy.org Why Use a Hybrid? Motivations for Hybrids Linked to business risk Linked to market risk Cannot hedge with derivatives Driven by investor needs Company hedges Company does not hedge Debt or equity are Not good enough

12. Copyright ©2001 Ian H. Giddy Hybrid Securities 12 giddy.org A Day in the Life...

13. Copyright ©2001 Ian H. Giddy Hybrid Securities 13 giddy.org Equity-Linked Eurobonds l Eurobonds with warrants  Marui l Convertible Eurobonds  Battle Mountaingold l Index-linked Eurobonds  Bank of Montreal

14. Copyright ©2001 Ian H. Giddy Hybrid Securities 14 giddy.org Warrants Theoretical Value Market Value Market Premium V a l u e o f W a r a n t ($) 0 Price Per Share of Common Stock ($)

15. Copyright ©2001 Ian H. Giddy Hybrid Securities 15 giddy.org Convertibles Conversion Value Straight Bond Value Market Value Market Premium V a l u e o f C o n v e r t i b l e B o n d ($) 0 Price Per Share of Common Stock

16. Copyright ©2001 Ian H. Giddy Hybrid Securities 16 giddy.org Nikkei-Linked 28,00019,000 PRINCIPAL REPAYMENT

17. Copyright ©2001 Ian H. Giddy Hybrid Securities 17 giddy.org Bank of Montreal Nikkei-Linked Note Bank of Montreal Japanese insurance companies US pension fund with Japan portfolio Bankers TrustNippon Credit

18. Copyright ©2001 Ian H. Giddy Hybrid Securities 18 giddy.org 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.

19. Copyright ©2001 Ian H. Giddy Hybrid Securities 19 giddy.org Carps III 100% CAPITAL-PROTECTED ZERO-COUPON USD EMTN LINKED TO FRANK RUSSELL JAPAN EQUITY FUND l Basic Structure l a. This is a USD Euro-Medium Term Note with a maturity of 3 years. l b. It carries a 100% capital guarantee on maturity (provided by Societe Generale rated Aa3 by Moody’s and AA- by S&P) l c.Being a zero-coupon Note, the yield is linked to the performance of the Frank Russell Japan Equity Fund. l Client Suitability l Appropriate for ‘sophisticated investors’ who: l a. require only 100% guarantee on capital on maturity l b. believe that Japan is on a recovery path and that the stock market of Japan will see significant gains over the medium term l c. believe that the Frank Russell Japan Equity Fund is capable of delivering a consistently above-market return with reduced risks.

20. Copyright ©2001 Ian H. Giddy Hybrid Securities 20 giddy.org Carps III l Client’s objectives l The “Guaranteed Minimum Return” product l How is this priced? Who else could benefit from it? 80859095 100105110115120125130135140145150 -20% -10% 0% 10% 20% 30% 40% 50% 60% Index Level at maturity (Initial index level = 100) Profit (Loss) with 100% Principal Protection Profit (Loss) with 90% Principal Protection Profit (Loss)

21. Copyright ©2001 Ian H. Giddy Hybrid Securities 21 giddy.org Medium-Term Notes: Anatomy of a Deal

22. Copyright ©2001 Ian H. Giddy Hybrid Securities 22 giddy.org 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.

23. Copyright ©2001 Ian H. Giddy Hybrid Securities 23 giddy.org 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

24. Copyright ©2001 Ian H. Giddy Hybrid Securities 24 giddy.org 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.

25. Copyright ©2001 Ian H. Giddy Hybrid Securities 25 giddy.org 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

26. Copyright ©2001 Ian H. Giddy Hybrid Securities 26 giddy.org 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.

27. Copyright ©2001 Ian H. Giddy Hybrid Securities 27 giddy.org 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

28. Copyright ©2001 Ian H. Giddy Hybrid Securities 28 giddy.org The Parties in the Deal SCOTTISH LIFE CSFB DEUTSCHE

29. Copyright ©2001 Ian H. Giddy Hybrid Securities 29 giddy.org The Deal in Detail SCOTTISH LIFE CSFB DEUTSCHE Deutsche sells 3-year floating rate note paying LIBOR - 3/8%

30. Copyright ©2001 Ian H. Giddy Hybrid Securities 30 giddy.org 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

31. Copyright ©2001 Ian H. Giddy Hybrid Securities 31 giddy.org 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)

32. Copyright ©2001 Ian H. Giddy Hybrid Securities 32 giddy.org 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

33. Copyright ©2001 Ian H. Giddy Hybrid Securities 33 giddy.org 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.

34. Copyright ©2001 Ian H. Giddy Hybrid Securities 34 giddy.org Option Pricing 94.5 Option Price = Intrinsic value + Time value Option Price Underlying Price 94.75 Time value depends on n Time n Volatility n Distance from the strike price Time value depends on n Time n Volatility n Distance from the strike price

35. Copyright ©2001 Ian H. Giddy Hybrid Securities 35 giddy.org Option Pricing Model 0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 93 94 95 96 FUTURES PRICE CALL OPTION PRICE

36. Copyright ©2001 Ian H. Giddy Hybrid Securities 36 giddy.org Value of Call Option INTRINSIC VALUETIME VALUE EXPECTED VALUE OF PROFIT GIVEN EXERCISE STRIKE FUTURES PRICE SHADED AREA: Probability distribution of the log of the futures price on the expiration date for values above the strike.

37. Copyright ©2001 Ian H. Giddy Hybrid Securities 37 giddy.org Black-Scholes Option Valuation C o = S o N(d 1 ) - Xe -rT N(d 2 ) d 1 = [ln(S o /X) + (r +  2 /2)T] / (  T 1/2 ) d 2 = d 1 - (  T 1/2 ) where C o = Current call option value. S o = Current stock price N(d) = probability that a random draw from a normal distribution will be less than d.

38. Copyright ©2001 Ian H. Giddy Hybrid Securities 38 giddy.org Breaking Down a Convertible: Unisys l 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?

39. Copyright ©2001 Ian H. Giddy Hybrid Securities 39 giddy.org Breaking Down a Convertible: Unisys

40. Copyright ©2001 Ian H. Giddy Hybrid Securities 40 giddy.org 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?)

41. Copyright ©2001 Ian H. Giddy Hybrid Securities 41 giddy.org Economics of Financial Innovation l Certain kinds of market imperfections allow hybrids to flourish l But innovation are readily copied; so only certain kinds of firm can profit from innovations. l There is a product cycle and profitability cycle of innovations.

42. Copyright ©2001 Ian H. Giddy Hybrid Securities 42 giddy.org What Conditions Permit Hybrids to Thrive? l Government Rules and Regulations Example: Japan Air Lines Yen-linked Eurobond l Tax Distortions Example: Money Market Preferred l Constraint on Issuers or Investors Example: Nikkei-Linked Eurobond l Segmentation-Driven Innovation Example: Collateralized Mortgage Obligations (CMOs)

43. Copyright ©2001 Ian H. Giddy Hybrid Securities 43 giddy.org Why Innovations Fail l The rationale evaporates l It’s too costly l It’s New Coke

44. Copyright ©2001 Ian H. Giddy Hybrid Securities 44 giddy.org Case Study: Banpu Convertible n How did this work? n Why did Banpu use this technique? n Why did investors buy it?

45. Copyright ©2001 Ian H. Giddy Hybrid Securities 45 giddy.org Banpu Convertible Huh?

46. Copyright ©2001 Ian H. Giddy Hybrid Securities 46 giddy.org Thai Time n 1994 n 1997 n 1999 n 2004

47. Prof. Ian Giddy New York University Leveraged Finance

48. Copyright ©2001 Ian H. Giddy Hybrid Securities 48 giddy.org M&A and Leverage n Leveraged buyout? Company has unused debt capacity n Leveraged recapitalization? n Takeover?

49. Copyright ©2001 Ian H. Giddy Hybrid Securities 49 giddy.org Typical LBO Sequence Company gets bloated or slack and stock price falls LBO offer made LBO completed Restructuring  Efficiencies  Divestiture s  Financial ? years3-9 months5-7 years IPO or sale of company

50. Copyright ©2001 Ian H. Giddy Hybrid Securities 50 giddy.org John M Case LBO John Case, owner Managers, buyers Company $20 million Payment: n Bank debt $6m n Seller note $4m n Sub debt with warrants $9.5m n Manager’s equity $0.5m

51. Copyright ©2001 Ian H. Giddy Hybrid Securities 51 giddy.org Simplified Balance Sheet for a restructured J.M.Case Company Assets Liabilities Cash$5762 Current Liab $1266 Other current 3236Bank loan 6000 Fixed & other 2184Case loan 4000 Good will10084Plug figure 9500 Managers’ equity 500 Total21,266Total21,266

52. Copyright ©2001 Ian H. Giddy Hybrid Securities 52 giddy.org John Case Cost of Capital

54. www.giddy.org

56. Copyright ©2001 Ian H. Giddy Hybrid Securities 56 giddy.org giddyonline.com Ian Giddy NYU Stern School of Business Tel 212-998-0332; Fax 917-463-7629 ian.giddy@nyu.edu http://www.giddy.org