Structured Finance Fixed Income Prof Ian Giddy New

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

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 u. Call price - par value = call premium u. Call feature can be valued independently u. The call feature is advantageous to the issuer, but it comes at a price Copyright © 2002 Ian H. Giddy Structured Finance 4

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

Treasury Bond Options http: //futures. tradingcharts. com/ Copyright © 2002 Ian H. Giddy Structured Finance 7

http: //www. numa. com/derivs/ref/calculat. htm Copyright © 2002 Ian H. Giddy Structured Finance 8

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

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 1 YEAR 2 YEARS 3 YEARS 4 YEARS 5 YEARS 10 YEARS 30 YEARS Copyright © 2002 Ian H. Giddy 5. 97 6. 28 7. 27 7. 52 7. 55 7. 76 8. 07 8. 26 AA CORPORATE VOLATILITY YIELDS OF TREASURY YIELD 6. 30 7. 40 7. 90 8. 34 8. 44 8. 72 9. 5% 9. 6% 10% 11. 2% 9. 9% 9. 7% Structured Finance 12

A Call to Guernsey n n Install the disk files into a directory called AKA Run AKA Use Valuation/Callable bonds Put in the data; enter 999 for years where there is no call option. Copyright © 2002 Ian H. Giddy Structured Finance 13

Guernsey: Results Copyright © 2002 Ian H. Giddy Structured Finance 14

Guernsey: Results Copyright © 2002 Ian H. Giddy Structured Finance 15

Forward Interest Rates Borrow for 6 months at 5% Invest for 3 months at 4% Lock in cost at ? Ans: 6% 5% 4% Copyright © 2002 Ian H. Giddy Structured Finance 16

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 for 6 months at 5% Invest for 3 months at 4% Lock in cost at 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

FRA Valuation How does the FRA’s value change over time? l It depends on what happens to Libor. l 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 19

Swaps: Mechanics and Valuation Fixed 8% GE 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

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 8%-Libor Chase 3 -mo Libor, floating Copyright © 2002 Ian H. Giddy Structured Finance 21

Swaps 8% Fixed GE Ongoing short-term funding Copyright © 2002 Ian H. Giddy Chase 3 -mo Libor, floating Structured Finance 22

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 Chase 3 -mo Libor, floating Copyright © 2002 Ian H. Giddy Structured Finance 23

Swaps: Applications of Valuation Fixed 9% Labatt’s RBC Floating Libor 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

Swaptions Swaption is an option on a swap: u. The right to enter into a new swap at a given date in the future, or u. The right to cancel an existing swap, or u. The 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 Bank Floating USD Libor s. a. Copyright © 2002 Ian H. Giddy Structured Finance 26

Swap Valuation and Swaptions 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

Swaption Quotations 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 Bank Floating Libor l 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

Using Options Technology in Investment and Financing Caps, collars, swaptions can be used in a number of ways to enhance financing: u. To hedge an asset. Eg floating rate borrowing + cap to hedge capped consumer loans. u. With a debt issue, to "strip" a feature off the bond. Eg issue callable bond, sell a swaption to a bank. u. To 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

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 11% CAP LIBOR Copyright © 2002 Ian H. Giddy Structured Finance 34

Copyright © 2002 Ian H. Giddy Structured Finance 35

Copyright © 2002 Ian H. Giddy Structured Finance 36

Cap Pricing Model Cap/Floor Rate Period in days Days to next coupon Yield volatility Copyright © 2002 Ian H. Giddy 12 91 30 21. 5 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

Medium-Term Notes: Anatomy of a Deal Copyright © 2002 Ian H. Giddy Structured Finance 39

Anatomy of a Deal Issuer: u. Looking for large amounts of floating-rate USD and DEM funding for its loan porfolio. u. Wants low-cost funds: target CP-. 10 u. Is not too concerned about specific timing of issue, amount or maturity u. Is willing to consider hybrid structures. Copyright © 2002 Ian H. Giddy Structured Finance 40

Anatomy of a Deal Investor: u. Has distinctive preference for high grade investments u. Looking for investments that will improve portfolio returns relative to relevant indexes u. Invests in both floating rate and fixed rate sterling and dollar securities u. Can buy options to hedge portfolio but cannot sell options Copyright © 2002 Ian H. Giddy Structured Finance 41

Anatomy of a Deal Intermediary: u. Has experience and technical and legal background in structure finance u. Has active swap and option trading and positioning capabilities u. Has clients looking for caps and other forms of interest rate protection. Copyright © 2002 Ian H. Giddy Structured Finance 42

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

The Issue 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

The Deal in Detail DEUTSCHE Deutsche sells 3 -year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE CSFB Copyright © 2002 Ian H. Giddy Structured Finance 47

The Deal in Detail DEUTSCHE Deutsche sells 3 -year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE For an additional 3/4% p. a. , Deutsche buys threeyear put option on 5 -year fixed-rate 8. 35% note to SL in 3 years CSFB Copyright © 2002 Ian H. Giddy Structured Finance 48

The Deal in Detail DEUTSCHE Deutsche sells 3 -year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE For an additional 3/4% p. a. , Deutsche buys three. For 1% p. a. , year put option on 5 -year Deutsche sells CSFB a swaption fixed-rate 8. 35% note to SL in 3 years (the right to pay fixed 8. 35% for 5 years in 3 years) CSFB Copyright © 2002 Ian H. Giddy Structured Finance 49

The Deal in Detail DEUTSCHE Deutsche sells 3 -year floating rate note paying LIBOR - 3/8% SCOTTISH LIFE For an additional 3/4% p. a. , Deutsche buys three. For 1% p. a. , year put option on 5 -year Deutsche sells CSFB a swaption fixed-rate 8. 35% note to SL in 3 years (the right to pay fixed 8. 35% for 5 years in 3 years) CSFB Copyright © 2002 Ian H. Giddy CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise CLIENT Structured Finance 50

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

n www. stern. nyu. edu

n www. giddy. org