Ian H. Giddy/NYU

Structured Finance-1

Structured Finance: Fixed Income Prof. Ian Giddy New York University

Structured Finance

Asset-backed securitization l Corporate financial restructuring l Structured financing techniques l

Copyright ©2002 Ian H. Giddy

Structured Finance 2

Ian H. Giddy/NYU

Structured Finance-2

Motivations for Issuing Hybrid Bonds 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?) l

Copyright ©2002 Ian H. Giddy

Structured Finance 3

“Hybrid” Features of A Bond Issue l Example:

callable bonds l Call Feature uCall

price - par value = call premium uCall feature can be valued independently uThe call feature is advantageous to the issuer, but it comes at a price

Copyright ©2002 Ian H. Giddy

Structured Finance 4

Ian H. Giddy/NYU

Structured Finance-3

Treasury Bonds

Source: bondsonline .com (May 3 2002) Copyright ©2002 Ian H. Giddy

Structured Finance 5

Treasury Bonds

http://stockcharts .com/ Copyright ©2002 Ian H. Giddy

Structured Finance 6

Ian H. Giddy/NYU

Structured Finance-4

Treasury Bond Options

http://futures.tradingcharts.com/ Copyright ©2002 Ian H. Giddy

Structured Finance 7

http://www.numa.com/derivs/ref/calculat/calculat.htm

Copyright ©2002 Ian H. Giddy

Structured Finance 8

Ian H. Giddy/NYU

Structured Finance-5

Assignment

Guernsey

Copyright ©2002 Ian H. Giddy

Structured Finance 9

Callable Bonds and Hybrid Securities General Principle: Callable bonds and other hybrid securities are simple or complex combinations of other individual securities

General Method: 1 Identify investor’s or issuer’s needs, constraints and views. 2 Break up bond into components and find value of the total. 3 Compare this with realistic alternatives. Is this the best way to satisfy investor’s and issuer’s needs and views? Copyright ©2002 Ian H. Giddy

Structured Finance 10

Ian H. Giddy/NYU

Structured Finance-6

A Call to Guernsey Which bond, priced at par, offers the best value? l A 4-year Sony Eurodollar bond paying 8.50%, callable at 100.25 in two years. l A 4-year BASF Eurodollar bond paying 8.48%, callable at 100.50 in three years. l A 4-year SNCF noncallable Eurodollar bond, paying 8.44%. Copyright ©2002 Ian H. Giddy

Structured Finance 11

Guernsey: Rates

March 24, U.S. TREASURY 1996 YIELD CURVE 3 MONTHS 5.97 1 YEAR 6.28 2 YEARS 7.27 3 YEARS 7.52 4 YEARS 7.55 5 YEARS 7.76 10 YEARS 8.07 30 YEARS 8.26

Copyright ©2002 Ian H. Giddy

AA CORPORATE VOLATILITY YIELDS OF TREASURY YIELD 6.30 9.5% 7.40 9.6% 7.90 10% 8.34 11.2% 8.44 9.9% 8.72 9.7%

Structured Finance 12

Ian H. Giddy/NYU

Structured Finance-7

A Call to Guernsey

n

Install the disk files into a directory called AKA Run AKA Use Valuation/Callable bonds

n

Put in the data; enter 999 for years where there is no call opti on.

n n

Copyright ©2002 Ian H. Giddy

Structured Finance 13

Forward Interest Rates Borrow Borrow for for 66 months months at at 5% 5% Invest Invest for for 33 months months at at 4% 4% Lock Lock in in cost cost at at ?? Ans: Ans: 6% 6% 7 6 5

5% 4%

4 3 2 1 0 0

Copyright ©2002 Ian H. Giddy

3 mo

6 mo

9 mo

1 yr

15 mo

18 mo

Structured Finance 16

Ian H. Giddy/NYU

Structured Finance-8

Calculating Implied Forward Rates I can buy a 2-year note or buy a 1-year note and reinvest it at some "forward" rate f: (1+y 2)2=(1+y 1)(1+f) Find f!

Copyright ©2002 Ian H. Giddy

Structured Finance 17

FRA Mechanics Borrow Borrow for for 66 months months at at 5% 5% Invest Lock Invest for for 33 months months at at 4% 4% Lock in in cost cost at at 6% 6%

SET RATE AT 6%

Copyright ©2002 Ian H. Giddy

IF LIBOR > 6%, B PAYS H IF LIBOR < 6%, H PAYS B HOW MUCH? PV[(LIBOR-6%)/4] Structured Finance 18

Ian H. Giddy/NYU

Structured Finance-9

FRA Valuation How does the FRA’s value change over time? l It depends on what happens to Libor. l

IF LIBOR > 6%, B PAYS H IF LIBOR < 6%, H PAYS B HOW MUCH? PV[(LIBOR-6%)/4]

SET RATE AT 6%

Copyright ©2002 Ian H. Giddy

Structured Finance 19

Swaps: Mechanics and Valuation Fixed 8%

GE GE

Chase Chase Floating USD Libor

Periodic exchanges of interest payments are made during the life of the swap. (The principal amount is not exchanged.)

Copyright ©2002 Ian H. Giddy

Structured Finance 20

Ian H. Giddy/NYU

Structured Finance-10

Interest Rate Swap: An Extended FRA The typical interest-rate swap is an exchange of a fixed for a floating interest rate for a period of time. Effectively, it involves paying the difference between a fixed rate and Libor, like a FRA: 8% Fixed

GE GE

8%-Libor

Chase Chase

3-mo Libor, floating Copyright ©2002 Ian H. Giddy

Structured Finance 21

Swaps

8% Fixed

GE GE Ongoing short-term funding

Copyright ©2002 Ian H. Giddy

Chase Chase 3-mo Libor, floating

Structured Finance 22

Ian H. Giddy/NYU

Structured Finance-11

Interest Rate Swap Valuation How does a swap’s value change over time? l It depends on what happens to the fixed rate (the “swap rate”) l

8% Fixed

GE GE

Chase Chase 3-mo Libor, floating

Copyright ©2002 Ian H. Giddy

Structured Finance 23

Swaps: Applications of Valuation Fixed 9%

Labatt’s Labatt’s

RBC RBC Floating Libor

l l l l l

Valuation Off-market swaps Cancellation Counterparty exposure Hedging swap positions

Copyright ©2002 Ian H. Giddy

FRN B O N D

Structured Finance 24

Ian H. Giddy/NYU

Structured Finance-12

Swaptions Swaption is an option on a swap: uThe

right to enter into a new swap at a given date in the future, or uThe right to cancel an existing swap, or uThe right to extend an existing swap.

Copyright ©2002 Ian H. Giddy

Structured Finance 25

Swap Valuation and Swaptions The value of a swap equals the "net worth" of the swap cash flows expressed as a balance sheet Fixed USD 9%

Labatt’s Labatt’s Labatt’s swap: Receive floating, pay fixed

Bank Bank Floating USD Libor s.a.

“ASSETS”

“LIABILITIES”

Receiving floating 6-mo US$ Libor Semi-annual for 5 years Principal US$100m Like a 5-year US$ FRN

Paying fixed 9% Annual for 5 years Principal US$100m Like a 5-year bond

Copyright ©2002 Ian H. Giddy

Structured Finance 26

Ian H. Giddy/NYU

Structured Finance-13

Swap Valuation and Swaptions Labatt’s swap: Receive floating, pay fixed “ASSETS”

”LIABILITIES”

Receiving floating 6-mo US$ Libor Semi-annual for 5 years Principal US$100m Like a 5-year US$ FRN

Paying fixed 9% Annual for 5 years Principal US$100m Like a 5-year bond

Copyright ©2002 Ian H. Giddy

Structured Finance 27

From Swap to Swaption What if Labatt's had the right to cancel this swap after 3 years? l To Labatt's, this would be exactly like a callable bond. In other words, swaptions are substitutes for callable bonds l Hence swaptions are priced like options on fixed rate bonds. l

Copyright ©2002 Ian H. Giddy

Structured Finance 28

Ian H. Giddy/NYU

Structured Finance-14

Swaption Quotations

Years 1 3 5 1 3 5

Customer pays fixed 9% 1 2 4 0.60-0.70 1.30-1.40 1.40-1.45 1.20-1.30 2.50-2.60 1.70-1.90 Customer receives fixed 9% 0.50-0.60 1.00-1.10 1.70-1.75 0.80-0.90 2.00-2.10 2.10-2.20

Copyright ©2002 Ian H. Giddy

Structured Finance 29

Swaption Symmetry l

Put-call parity says: “A put option plus a long position in the underlying is the same as a call option” A 7-YEAR SWAP Fixed 9%

Labatt’s Labatt’s l

Bank Bank Floating Libor

The bank is “long the underlying swap” (receiving fixed). If it has the right to cancel the swap (pay fixed 9%) after 5 years, this combination is the same as the right to receive fixed 9% from years 5 to 7.

Copyright ©2002 Ian H. Giddy

Structured Finance 30

Ian H. Giddy/NYU

Structured Finance-15

Using Options Technology in Investment and Financing Caps, collars, swaps, swaptions can be used in a number of ways to enhance financing: uTo

hedge an asset. Eg floating rate borrowing + cap to hedge capped consumer loans. uWith a debt issue, to "strip" a feature off the bond. Eg issue callable bond, sell a swaption to a bank. uTo take a view on the direction or volatility of interest rates. Eg. sell a swaption. Copyright ©2002 Ian H. Giddy

Structured Finance 31

Caps and Floors An interest-rate collar involves buying a cap and selling a floor: RATE

7%

5%

TIME Copyright ©2002 Ian H. Giddy

Structured Finance 32

Ian H. Giddy/NYU

Structured Finance-16

Caps, Floors and Collars l l l

Cap: Agreement to compensate buyer when interest rate exceeds a specified ceiling. Floor: Agreement to compensate buyer when interest rate falls below a specified floor. Collar: A simultaneous purchase of a cap and sale of a floor. Net cost is the price of the cap less the value of the floor. Example: u If

LIBOR > 12% cap, bank pays borrower the difference u If LIBOR < 4% floor, borrower pays bank the difference l

Swaption: Option on a swap.

Copyright ©2002 Ian H. Giddy

Structured Finance 33

Decomposing Option Products: Example of an Interest Rate Cap 13 12

11% CAP

11 LIBOR 10 9 8 Today

Copyright ©2002 Ian H. Giddy

1st Put

2nd Put

3rd Put

Structured Finance 34

Ian H. Giddy/NYU

Structured Finance-17

Copyright ©2002 Ian H. Giddy

Structured Finance 35

Copyright ©2002 Ian H. Giddy

Structured Finance 36

Ian H. Giddy/NYU

Structured Finance-18

Cap Pricing Model Cap/Floor Rate Period in days Days to next coupon Yield volatility

12 91 30 21.5

No. Days to Fut. or T-Bill Call Exp. Forward rate Price Rate (in %)

1 2 3 4 5 6 7 8

30 121 212 303 394 485 576 667

8.36 8.85 9.29 9.69 10.06 10.4 10.72 11.02

7.06 7.56 7.82 8.1 8.4 8.55 8.84 8.96

0.9 0.77 0.65 0.56 0.5 0.45 0.42 0.39

Put Price (in %)

Floor Price (in %)

0.0 0.0 0.0 0.02 0.05 0.09 0.14 0.18

0.9 1.67 2.33 2.89 3.39 3.84 4.26 4.65

Copyright ©2002 Ian H. Giddy

Cap Put Price Hedge (in %) Ratio

0.0 0.0 0.01 0.03 0.08 0.17 0.31 0.49

0.0% 0.2% 3.5% 10.7% 18.8% 26.1% 32.2% 37.2%

Structured Finance 37

Factors Influencing Cap Prices l l l

Length Steepness of yield curve Volatility Cap

Forward Rates

Yield Curve (Zero rates)

Volatility Curve

Copyright ©2002 Ian H. Giddy

Structured Finance 38

Ian H. Giddy/NYU

Structured Finance-19

Medium-Term Notes: Anatomy of a Deal

Copyright ©2002 Ian H. Giddy

Structured Finance 39

Anatomy of a Deal Issuer: uLooking

for large amounts of floating-rate USD and DEM funding for its loan porfolio. uWants low-cost funds: target CP-.10 uIs not too concerned about specific timing of issue, amount or maturity uIs willing to consider hybrid structures.

Copyright ©2002 Ian H. Giddy

Structured Finance 40

Ian H. Giddy/NYU

Structured Finance-20

Anatomy of a Deal Investor: uHas

distinctive preference for high grade investments uLooking for investments that will improve portfolio returns relative to relevant indexes uInvests in both floating rate and fixed rate sterling and dollar securities uCan buy options to hedge portfolio but cannot sell options Copyright ©2002 Ian H. Giddy

Structured Finance 41

Anatomy of a Deal Intermediary: uHas

experience and technical and legal background in structure finance uHas active swap and option trading and positioning capabilities uHas clients looking for caps and other forms of interest rate protection.

Copyright ©2002 Ian H. Giddy

Structured Finance 42

Ian H. Giddy/NYU

Structured Finance-21

The Deal 1

2

3

4

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

Copyright ©2002 Ian H. Giddy

Structured Finance 43

The Deal / 2 5

6

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.

Copyright ©2002 Ian H. Giddy

Structured Finance 44

Ian H. Giddy/NYU

Structured Finance-22

The Issue l l l

l l l l l

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

Copyright ©2002 Ian H. Giddy

Structured Finance 45

The Parties in the Deal

DEUTSCHE

SCOTTISH LIFE

CSFB Copyright ©2002 Ian H. Giddy

Structured Finance 46

Ian H. Giddy/NYU

Structured Finance-23

What’s Really Going On? Note: l

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 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.

Copyright ©2002 Ian H. Giddy

Structured Finance 51

Structured Notes l l l

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.

Copyright ©2002 Ian H. Giddy

Structured Finance 52

Ian H. Giddy/NYU

Structured Finance-24

Contact Info Ian H. Giddy NYU Stern School of Business Tel 212-998-0426; Fax 212-995-4233 [email protected] http://giddy.org

Copyright ©2002 Ian H. Giddy

Structured Finance 57