The Global Capital Market Prof Ian Giddy New

The Global Capital Market Prof. Ian Giddy New York University

The International Capital Market International bank financing l Eurobonds, foreign bonds and global bonds l “A Day in the Life” l u. The secondary market u. The primary market l Structured financing Copyright © 1996 Ian H. Giddy The Global capital Market 2

Short-Term Financing: Evolution DIRECT ENHANCED INTERMEDIATED Copyright © 1996 Ian H. Giddy COMMERCIAL PAPER

Alternative Sources of Short-Term Financing FINANCING DOMESTIC DEBT EQUITY LOANS EUROMARKET LOANS SYNDICATED EUROCREDITS NOTE ISSUANCE FACILITIES EUROCOMMERCIAL PAPER Copyright © 1996 Ian H. Giddy The Global capital Market 8

A Revolver RUF Structure: u. Arranger u. Underwriting banks u. Tender panel u. Agent

RUF Stuff Need lots of money fast? Have trouble accessing CP market? Confident of always being able to access the short-term market? YES Arrange syndicated credit YES Arrange Euronote program NO Don’t issue paper YES Borrow from banks Arrange RUF or MOF: Underwritten Euronote program Need funds? Cannot sell paper at L+10 bp? Issue Euronotes or other paper Copyright © 1996 Ian H. Giddy The Global capital Market 10

Alternative Sources of Long-Term Financing l l Bank credits - syndicated lending and facilities Bonds FINANCING DEBT EQUITY u. Domestic, foreign, Euro u. Public, private u. Structured, such as principle-indexed notes Medium-term notes l Asset-backed financing and leasing l Project financing l Copyright © 1996 Ian H. Giddy The Global capital Market 11

Long-Term Financing: Evolution DIRECT ENHANCED INTERMEDIATED Copyright © 1996 Ian H. Giddy PUBLIC BONDS

The Global Bond Market Domestic bonds l Foreign bond l (Issued within country of currency, by nonresident issuers) l Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) l Global Bonds (Issued in the domestic and the Eurobond markets simultaneously) Copyright © 1996 Ian H. Giddy The Global capital Market 13

The Global Bond Market Domestic bonds l Foreign bond l (Issued within country of currency, by nonresident issuers) l Eurobonds (Issued and sold in a jurisdiction outside the country of the currency of denomination) l Global Bonds (Issued in the domestic and the Eurobond markets simultaneously) Copyright © 1996 Ian H. Giddy The Global capital Market 14

International Bond Markets are Linked l Issuers and investors compare terms in the domestic and Eurobond markets, which are linked across currencies via currency swaps BOND MARKETS WITHIN COUNTRY OF CURRENCY BOND MARKETS OUTSIDE COUNTRY OF CURRENCY Copyright © 1996 Ian H. Giddy Domestic US Domestic Japanese - Gov't - Corporate Foreign Bonds "Yankee" Foreign Bonds "Samurai" Currency Swaps Eurodollar Bond Market Euroyen Bond Market Long-dated Forward Exchange The Global capital Market 15

Foreign Bonds l l A foreign bond is a bond issued in a host country's financial market, in the host country's currency, by a foreign borrower The three largest foreign bond markets are Japan, Switzerland, and the U. S. , representing issuance of about $40 billion in bonds annually Copyright © 1996 Ian H. Giddy The Global capital Market 16

Private Placements and Rule 144 A The private placement exemption from registration and disclosure is extended to Eurobonds as long as the U. S. investors meet the following requirements: u They are large and sophisticated u There are only a few investors u They have access to information and analysis similar to that which would ordinarily be contained in a registered offering prospectus u They are capable of sustaining the risk of losses, and u They intend to purchase the bonds for their own investment portfolios, and not for resale. Copyright © 1996 Ian H. Giddy The Global capital Market 17

Characteristics of Eurobonds Issued outside country of currency l Not subject to domestic registration or disclosure requirements l In most cases take form of private placements l Placed through syndicates in many countries who sell principally to nonresidents l Bonds are structured so as to be free of withholding tax l Bearer form But. . . l Eurobonds usually influenced de facto by government and banks of country of currency l Copyright © 1996 Ian H. Giddy The Global capital Market 18

Global Bonds Copyright © 1996 Ian H. Giddy The Global capital Market 19

Key Dates in the Issuance of a Eurobond Copyright © 1996 Ian H. Giddy

Key Players in the Issuance of a Eurobond SELLING GROUP Copyright © 1996 Ian

Who Gets What Fees, percent Fees, amount Net price Price paid by investor (in theory) Price paid by member of selling group Price paid by member of underwriting group Price paid by managers (plus "praecipium" paid to lead manager) Copyright © 1996 Ian H. Giddy 60% 0. 90 101. 50 100. 60 60%+20% 0. 90+0. 30 100. 30 60%+20% 0. 90+0. 30 100. 00 The Global capital Market 22

Pricing Eurobonds in the Secondary Market l l What "spread to Treasury" should it yield relative to similar bonds--credit risk, duration and liquidity--trading in the secondary market? Use the desired yield to maturity to find its present value at the next coupon date. Find today's present value of that amount, including the coupon to be paid Actual price is quoted as "clean price, " meaning not counting accrued interest Copyright © 1996 Ian H. Giddy The Global capital Market 23

The Eurobond Secondary Market Copyright © 1996 Ian H. Giddy The Global capital Market

Eurobond Secondary Market Quotations l Examine the straight bonds listed u. What determines the yields? u. The bid-offer spreads? u. Does this differ by currency? Can you explain the pricing of the floating rate notes? l Copyright © 1996 Ian H. Giddy The Global capital Market 25

A Day in the Life of the Eurobond Market l Examine the deals u. Why were each done in that particular form? u. What determines the pricing? l Can you break the hybrids into their component parts? Copyright © 1996 Ian H. Giddy The Global capital Market 26

A Day in the Life. . . Copyright © 1996 Ian H. Giddy The

Asset-Backed Eurobonds Legal risk: u. Legal structure: sale of assets to separate subsidiary that issued ABS. Default risk: u. Overcollateralization dictated by rating agencies u. Replenishment of collateral u. Third-party garantees. Prepayment risk: u. Early Copyright © 1996 Ian H. Giddy redemption caused by “spread trigger”. The Global capital Market 28

Equity-Linked Eurobonds l Eurobonds with warrants u. Marui l Convertible Eurobonds u. Battle l Mountaingold Index-linked Eurobonds u. Bank Copyright © 1996 Ian H. Giddy of Montreal The Global capital Market 29

Equity Financing Choices Warrants Convertibles Equity ADRs Copyright © 1996 Ian H. Giddy Common

Values and Market Premium V a l u e o f C o n v e r t i b l e Conversion Value Market Premium Straight Bond Value B o n d ($) 0 Price Per Share of Common Stock Copyright © 1996 Ian H. Giddy The Global capital Market 31

Copyright ã 1994, Harper. Collins Publishers Values and Warrant Premium V a l u e o f W a r r a n t Market Value Market Premium Theoretical Value ($) 0 Copyright © 1996 Ian H. Giddy Price Per Share of Common Stock ($) The Global capital Market 32

“Hybrid” Features of A Bond Issue l Conversion Feature - compound option l Warrants - two instruments l Index-linked bonds l Call Feature u. Bond value = straight bond value - call value These are all example of hybrid bonds and should be priced by decomposition Copyright © 1996 Ian H. Giddy The Global capital Market 33

International Equity Markets and Portfolio Diversification l l l No well-accepted international version of the capital asset pricing model. The benefits of diversification globally are empirical issues. The empirical case for international diversification has two components. Establish the riskiness of foreign investment, and the extent to which combining a foreign with a domestic portfolio reduces risk. u Even if it reduces risk, does foreign investment also reduce expected return? u l Then what we have to do is make sure we understand how international diversification is best achieved. Copyright © 1996 Ian H. Giddy The Global capital Market 34

Portfolio Return and Risk Portfolio return: where wi are the weights of each asset in the portfolio. (Expected return is simply the weighted sum of the individual asset returns. ) Portfolio variance: When i = j, the term wiwj. Fi. Fj. Dij becomes wi 2 Fi 2. Copyright © 1996 Ian H. Giddy The Global capital Market 35

The Minimum-Variance Frontier of Risky Assets E(r) Efficient frontier Individual assets Global minimumvariance portfolio

Optimal Overall Portfolio E(r) Indifference curve CAL P Opportunity set Optimal complete portfolio Copyright

The Global Efficient Frontier Copyright © 1996 Ian H. Giddy The Global capital Market

Evidence Suggests Index Funds are Not for the International Investor l l l For the international investor the capitalizationweighted portfolio may not be the optimal one. The reason is market segmentation. The world stock market is not efficient yet, the evidence suggests, at least not in the "mean-variance efficiency" sense that is required by the CAPM. Because of real exchange risk (deviations from PPP), what is the optimal portfolio for an investor in one country may not be the optimal portfolio for an investor in another, even if there were a single risk-free asset acceptable to both. Studies confirm these propositions Copyright © 1996 Ian H. Giddy The Global capital Market 39

International Portfolio Optimization: Passive vs Active Portfolios (Let the proportions of all possible assets vary until the optimal proportions are found. ) The results of letting the computer find the best proportions for various levels of return: Copyright © 1996 Ian H. Giddy The Global capital Market 40

Obstacles to International Investment Might Include: Information barriers. l Political and capital control risks. l Foreign exchange risks. l Restrictions on foreign investment and control. l Taxation. l Higher costs. l Copyright © 1996 Ian H. Giddy The Global capital Market 41

Conclusion: The international equity market is imperfect l Hence there may be advantages to international equity issuance l How should companies achieve this? l Copyright © 1996 Ian H. Giddy The Global capital Market 42

Financing with Structured Securities Prof. Ian Giddy New York University

Principles of Innovation Through Financial Engineering 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 © 1996 Ian H. Giddy The Global capital Market 44

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 © 1996 Ian H. Giddy The Global capital Market 46

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 © 1996 Ian H. Giddy The Global capital Market 47

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 © 1996 Ian H. Giddy The Global capital Market 48

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 Copyright © 1996 Ian H. Giddy The Global capital Market 49

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. Copyright © 1996 Ian H. Giddy The Global capital Market 50

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 © 1996 Ian H. Giddy The Global capital Market 51

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 © 1996 Ian H. Giddy CSFB sells the swaption to a corporate client seeking to hedge its funding cost against a rate rise CLIENT The Global capital Market 56

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 © 1996 Ian H. Giddy The Global capital Market 57

Motivations for Issuing Hybrids 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 © 1996 Ian H. Giddy The Global capital Market 58

The International Capital Market International bank financing l Eurobonds, foreign bonds and global bonds l “A Day in the Life” l u. The secondary market u. The primary market l Structured financing Copyright © 1996 Ian H. Giddy The Global capital Market 59