Global Financial Markets
by Ian H. Giddy

 
Understanding and Using
     Hybrid Financial Instruments

 

Contents: Constructing the Edifice--Economics of Financial Innovation--Competition and the Product Cycle in Financial Innovations--Sources of Innovations--Transactions and Monitoring Costs--Regulation--Taxes--Constraints--Market Segmentation--Box: Asset-Backed Securities in Turkey--Understanding New Instruments: The Building Block Approach--Hedging and Managing New Instruments: The Functional Method--Box: Application: Valuation of an Oil-Linked Bond--Hybrids in Corporate Financing--Box: Structured Financing: A Sequence of Steps--Global Financial Markets in the Next Decade--Summary1



Constructing the Edifice

The international financial market has altered dramatically in the last decade, and is likely to continue to do so. As we have seen in previous chapters the Eurobond market has proved fertile ground for the introduction of many experimental techniques, while the recent opening up of domestic capital markets may augur a burgeoning of instruments designed to meet the requirements of investors and issuers in the home markets. Today's potential investor or issuer is confronted with dual currency bonds, reverse dual currency bonds, with swaps and options and swaptions and captions, and with "bunny bonds" and "bull and bear" bonds and TIGRS and Lyons. Flip-flops and retractables and perpetuals and Heaven-and-Hell bonds. Bonds linked to the Nikkei index or German Bund futures contracts or the price of oil. What's it all about, one has to wonder. Who buys these things? Who issues them, and why?

This chapter introduces a practical approach to the analysis and construction of innovative instruments in international finance. Many instruments of the international capital market, new or old, can be broken down into simpler securities. These elementary securities include zero-coupon bonds, pure equity, spot and forward contracts and options. Later in this chapter, for example, we will analyze the breakdown of a dual currency bond into a conventional coupon-bearing bond and a long-dated forward exchange contract. Combining or modifying basic contracts is what gives us many of the innovations we see today, and if we understand the pricing of bonds, forward contracts and the like,  we can in many cases estimate the price of complex-sounding instruments. When one encounters a new technique, one seeks to understand its component elements. We call this the building block approach. We'll see numerous examples in the pages that follow.

The building block method also enables us to go a step further: to understand the role of such securities in a portfolio of assets or liabilities. An extension of the building block approach is one that teaches us the behavior of innovative securities, alone or in combination. Simply stated, this functional method regards every such instrument or contract as bearing a price or value, which in turn bears a unique relationship to some set of variables such as interest rates or currency values. The more one can break the instrument down into its component parts or building blocks, the easier it is to specify how the instrument's value will change as the independent variables change.

Once we know how the instrument is constructed and hence how its value behaves, we can readily compare it against existing instruments which, alone or in combination, produce the same behavior. For example, some instruments' value varies with market interest rates, so that they are bond-like; others are affected by the condition of the issuing company, so that they are more equity-like. Many instruments combine elements of both. Each should be priced in accordance with the price of comparable instruments; if they are not, there may be a mispricing. The functional approach can be of great practical value to investors and issuers who wish to better understand the risks of instruments offered to them by banks. The approach can also be used to identify arbitrage opportunities between instruments, and to hedge one instrument with another.

We begin by seeking to explain why it is that new instruments are introduced, and which are likely to succeed.

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Economics of Financial Innovation

No financial innovation can be regarded as useful, nor will it survive, unless it creates benefits to at least one of the parties involved in the contract. These benefits could involve lower costs of capital for the issuer or higher returns for the investor. The benefit could be lower taxes paid. Or a reduction in risk, such as foreign exchange exposure of a corporation or government. More generally, the contribution of any financial innovation lies in the extent to which it helps complete the set of financial contracts available for financing or investing, positioning or hedging. They are introduced in response to some market imperfection.
 

Example

In the early 1980s certain German banks introduced investment instruments whose return was equal to the change in the German stock market index, the DAX, including reinvested dividends. This enabled German individual investors to overcome the absence of an equity index futures contract in Germany and to avoid the high fees charged by investment trusts.

 
But even if both the investor and the issuer are better off, there will only be a net gain if these benefits more than offset the costs of creating the innovation. These costs include research and development, marketing and distribution costs. Moreover, the firm providing the innovation must be able to capture or appropriate some of the benefits generated.

One fundamental factor inhibiting investors' demand for new instruments is that something new and different tends to be inherently illiquid. If an instrument is one of a kind, traders cannot easily put it into a category that allows it to be traded at a predictable price and in a positioning book along with similar instruments. And to the extent that the new instrument is difficult to understand, the costs of overcoming information barriers may inhibit secondary market development.

Some innovations may actually destroy value, because they are misunderstood by one party to the contract. The instrument does not behave in the way it is described as behaving. Or one aspect of the risk of the instrument (such as the credit risk of swaps) is not fully appreciated by one party. The excessive investment by U.S. savings and loan institutions in high-yield "junk" bonds in the 1980s can be seen in this light. These securities were described as bonds with disproportionately high yields. Yet a functional analysis of their behavior reveals that they were much more akin to equity than to bonds, and so should have borne a return like the equity return of the issuing company. Superficial analysis can lead to completely inappropriate investment or financing.

In many instances the investor or issuer may not be aware that he could have done the same thing cheaper via another combination of instruments. This is not an indictment of the banker promoting the instrument. In principle one can always find some way in which the issuer (for example) could have done better had her investment banker more fully informed her of all the alternatives. Bond salespeople and corporate finance specialists do not have an obligation to fully inform the client about all the alternatives (including competitors' products), unless that information is explicitly paid for. There are many situations in which the investor or issuer could in principle have found a cheaper solution elsewhere, but faced transactions costs, regulations or high costs of information-gathering that prevented ready access to the ostensibly cheaper alternative.

One way to interpret this is to describe financial product innovations as "experience goods." They must be consumed before their qualities become evident.

For innovations to be produced they must provide an above average return. Innovation of any kind involves the production of an information-intensive intangible good whose value is uncertain. While often costly to produce, new information can be used by any number of people without additional cost: it is a common good. The socially optimal price of a public good is zero. Indeed the ease of dissemination of new information makes it likely that its price will quickly fall to zero. However if this new information, once produced, bears a zero price, there is little or no private incentive for the production of innovations. There is no effective patent protection for financial instruments.

Yet a few firms seem to have been leaders in the production of innovations. Because financial products are experience goods, it may be that customers will tend to purchase new instruments and services chiefly from firms that have a reputation for initiating techniques of sound legality and predictable risk. Whenever the true risks, returns or other attributes of the new instrument are difficult to ascertain, there will be fixed information costs that serve as a barrier to acceptance of that instrument. The imprimatur of a reputable firm can allay investors' or issuers' fears. This is particularly true where the issue must be done quickly to take advantage of a "window" in the market, as the example of the first "collared sterling Euro floating rate note" shows.

Hence, despite the absence of legal proprietary rights, reputable banks and other financial institutions will have a temporary monopolistic advantage that enables them to appropriate returns from investment in the development of financial innovations. Other, perhaps more inventive, firms and individuals will tend to be absorbed by those who command a temporary monopoly.

Example

In the autumn of 1992 Britain dropped out of the European Exchange Rate Mechanism, freeing its domestic monetary policy from the constraints of a tie to the Deutschemark. On Tuesday, January 26, 1993, the Bank of England lowered the base rate, Britain's key short term rate, from 7% to 6%. On Thursday of that week Salomon Brothers in London led the first issue of collared floating-rate notes in sterling. The bond was a £100 million 10-year issue for the Leeds Permanent Building Society.

The deal offered investors LIBOR flat, with a minimum interest rate of 7 percent, 7/8 points higher than the current six-month London interbank offered rate, and a maximum of 11 percent. This is typical of the collared FRN structure, of which over $8 billion had been done in dollar-denominated form at the time. Collared FRNs incorporate a floor and a cap on the floating rate, with the floor being above current money market rates to attract coupon-hungry investors. The steep yield curve in the United States in the early 1990s made it possible for issuers to sell caps and buy floors in the over-the-counter derivatives market, and to use them to subsidize the cost of the issue while offering the investor an above-market yield, at least initially.

Salomon Brothers had arranged a number of deals of this kind in the dollar Eurobond market, and had done preparatory work for a sterling version. It was not until the base rate cut made the British yield curve steepen that it became viable, however, and Salomon was quick to exploit the window. The opportunity to reduce funding costs, and confidence that Salomon had the experience and credibility to get it right, are factors that gave Leeds Permanent the confidence to pioneer the structure in sterling. Similar collared FRNs were soon issued by other UK building societies and banks. 

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Competition and the Product Cycle in Financial Innovations

The advantage certain firms have in new instruments is, before long, eroded as uncertainty is reduced and clients can more confidently turn to lower-cost imitators. The high initial returns are eroded by competition from other banks as well as by the market forces that tend to eliminate those imperfections that gave rise to the innovation in the first place. The product may become a "commodity." For example, when interest rate caps were first introduced, corporate acceptance was long and difficult and only a few firms with high credibility were able to profit from them, and this only because the margins were substantial. As familiarity and acceptance increased,  the field was invaded by many banks and securities houses with the ability to trade and broker these interest rate options and prices of caps were driven down to a level resembling that of the underlying options. At this point the low-cost producers assumed a large market share.2
This sequence can be illustrated by means of the "product life cycle" diagram familiar to many readers. Financial innovations behave like other new products, albeit with a faster dissemination rate. Some financial innovations, however, set in motion a different process, one which leads to their demise. That process is nor a market one but a political/regulatory process. Many innovations, after all, are designed to circumvent regulations, restrictions and taxes. The regulatory authorities, seeing that the technique has an erosive effect on their jurisdiction, react by closing loopholes or by eliminating the barrier that motivated the innovation in the first place.
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Sources of Innovations

The majority of financial innovations are just different ways of bundling or unbundling more basic instruments such as bonds, equities and currencies. Of course there are many, many different ways of rearranging the basic financial products. So two puzzles arise. First, why do particular innovations seem to emerge and thrive? And second, why do investors or issuers need the innovation in the first place: what's to stop them from putting together the structure from the basic instruments themselves, rather than paying investment bankers to do so? The answer lies in imperfections--market imperfections that make the whole worth more than the sum of the parts, and which constrain investors or issuers or both from constructing equivalent positions out of elemental instruments. Many of these imperfections arise from barriers to international arbitrage, from currency preferences, and from the different conditions investors and issuers face in different countries.

The example of convertible Eurobonds will serve to illustrate this concept.
 

Example
In 1992 a British company, Carlton, issued a £64.25 million convertible, bearer form Eurobond. The subordinated issue had a fifteen year life and paid a coupon of 7.5%, at least 2% lower than comparable straight Eurobonds issued at the time.

The late 1980s and early 1990s saw a huge volume of Eurobonds with equity features issued by U.S., Japanese and European corporations. A convertible bond pays a lower-than-normal coupon but gives the investor the right to exchange each bond for a certain number of shares in the issuing company. Once the issuer's share price rises by more than the conversion "premium" the investor has more to gain from conversion than from holding the bond to maturity. As in the Carlton case, the company often has a call option, giving it the ability to compel the investor to choose between redemption and conversion when the shares exceed the conversion price by a comfortable margin. This has the effect of forcing conversion. The question: why would one choose to buy this hybrid instrument rather than a bond alone, or an option on the stock alone, or--if the investor wants the benefit of both--a combination of the two? Three answers are possible :
 

First, one might say that perhaps there is no domestic equity option market available to the investor, possibly because regulations do not permit it, giving rise to the need for an international proxy. This has been true in Japan, which helps explain why so many Japanese companies have issued Eurobonds with warrants.3 The latter, being separable, provide a better solution to the incomplete markets argument than convertibles. And there are active equity option markets in other countries, such as the United States and Britain.
A second explanation lies in the freedom of certain offshore instruments from domestic taxes. Eurobonds are issued in locations free of withholding taxes and in bearer form, which helps preserve investor anonymity. But all shares are issued by the parent company directly, and are listed and registered in the home country. Registration means that the issuer, and therefore the fiscal authorities, are told the share owner's identity. So individual investors seeking to avoid paying taxes on their equity portfolios find that convertible Eurobonds offer the "play" of equity without undue tax risk. When it comes time to convert, the bonds are sold to equity investors in the country of the issuer who are not concerned with the fact that the shares are registered.

Many convertible bonds are also bought by institutional investors that do not have a tax avoidance motivation. These buyers are getting around a regulatory or self-imposed rule restricting equity investments. Some pension funds, for example, are not permitted to buy equity. Convertible bonds give them participation in the upside gain on the shares while guaranteeing interest and repayment of the bonds should the shares fall. Sound conservative? The problem is that the market price of a convertible bond rises and falls like the shares when the embedded option is in the money or near the money. So the institutional investor may be violating the spirit if not the letter of the restriction.

 
At least five kinds of market imperfection, alone or together, seem to make the whole worth more than the sum of the parts in hybrid international securities. Thus we can identify (1) innovation that results from transactions costs or costs of monitoring performance (2) regulation-driven innovation, (3) tax-driven innovation, (4) constraint-driven innovation, and (5) segmentation-driven innovation. We will illustrate some of these by reproducing the "tombstone" announcements, which serve no purpose except to proclaim the bankers' prowess: a sort of investment banker's graffiti.

Transactions and monitoring costs are the explanation for many instruments in today's capital market. Most mutual funds offer individual and medium sized investors economies of scale to overcome the erosive effect of brokerage, custody and other costs associated with buying, holding and selling securities, costs which can be particularly high for international investors. Ecu-denominated bonds and other currency-cocktail bonds offer built-in currency diversification. The costs of assessing and monitoring performance on contracts can also deter many from employing simple techniques like forwards, debt and options. Where monitoring costs are high, credit risk must be eliminated, usually by means of one or both of two techniques: collateral and marking-to-market with cash compensation. Thus the futures contract enables poor-credit companies to hedge future currency, interest rate and commodity price movements without monitoring costs.

For investors who wish to take a position in a currency, equity or commodity, credit risk considerations often preclude them from doing forwards or swaps directly. They can, however, buy bonds whose interest or principal varies with the market price of interest--their "counterparty," the issuer, has no credit risk, for instead of the investor making a payment if he loses, the issuer simply reduces the interest or principal to be paid to the investor. A callable bond falls into this category.

Regulation-driven innovations. Laws and government regulations restrict national capital markets in many ways. Banks, issuers, investors and other market players are prevented from doing certain kinds of financing or entering into certain kinds of contracts. For example banks are told that a certain proportion of their liabilities must be in a form that qualifies as "capital" for regulatory purposes, a requirement that stems from the international agreement known as the "Basle Accord." Hence the financial papers are filled with announcements of "convertible exchangeable floating rate preferred stock" and the like,  fashioned purely to meet the capital requirements. Issuers may not be permitted to issue public bonds without intrusive disclosure. Insurance companies may not be allowed to invest more than, say, 20% of their assets abroad despite a paucity of domestic investment opportunities. These laws and regulations may be well intentioned but may have unanticipated side effects or become redundant as markets and institutions mature and economic conditions change. Yet entrenched interests develop around certain rules making them difficult to changes. Sometimes, as when interest rates or taxes reach unusual levels, or when competition threatens, financial market participants find it worthwhile to devise ways to overcome the restrictive effect of outdated or misguided regulations.

For example, in the 1980s foreign investment in Korean equities was severely restricted. One way to get around this was for prominent Korean companies to issue Eurobonds that were convertible into common stock. Since the bonds behaved like equity, they served the international investor's purpose, to a degree.
 

February 1982 These bonds having already been sold this announcement appears as a matter of record only 
JAL
 
 
 
 

Japan Air Lines Company, Ltd.

(incorporated with limited liability under the laws of Japan)

U.S. $ Denominated 7f% Yen-Linked Guaranteed Notes 1987

of a principal amount equivalent to

Yen 8,600,000,000

Unconditionally and irrevocably guaranteed by

Japan

Daiwa Securities Co. Ltd   Morgan Guaranty Ltd   Bank of Tokyo Intl Ltd   Banque de Paris et des Pays-Bas   Credit Suisse First Boston Ltd   Development Bank of Singapore   IBJ International Ltd   Kuwait Investment Company (S.A.K.)   Nikko Securities Co. (Europe) Ltd   Salomon Brothers Intl   Swiss Bank Corporation Intl Ltd   S.G. Warburg & Co. Ltd 

Algemene Bank Nederland N.V. Amro intlBanco del Gottardo Bank of America Intl ltdBank of Tokyo (Holland) N.V.   Banque de l'Indochine et de Suez   Banque de Neuflize, Schlumberger, Mallet   Banque Nationale de Paris   Barclays Bank   Baring Brothers & co. Ltd   Caisse des Depots et Consignations   Chase Manhattan Ltd   Chemical Bank Intl Group   Citicorp Intl group   Commerzbank Aktiengesellschaft   Continental illinois Ltd   County bank Ltd   Credit Commercial de France   Credit Industriel et Commercial   Credit Lyonnais   Creditanstalt-Bankverein  Dai-Ichi Kangyo Intl Ltd   DBS-Daiwa Securities Intl Ltd   DG Bank Deutsche Genossenschaftsbank   Dillon, read Overseas Corporation   Fuji International Finance Ltd   Goldman Sachs Intl Corp.   Hill, Samuel & CO. Ltd   The Hongkong Bank Group   Industriel Bank Von Japan (Deutschland) Aktiengesellschaft   Kuwait Foreign Trading Contracting and Investment Co.   Kidder, Peabody Intl Ltd   Kleinwort, Benson Ltd   Lloyds Bank Intl Ltd   LTCB International Ltd   Manufacturers Hanover Ltd   Merrill lynch Intl & Co.   Mitsubishi bank (Europe) S.A.   Mitsui Finance Europe Ltd   Samuel Montague & Co. ltd   Morgan Grenfell & Co. Ltd   Morgan Guaranty Pacific Ltd   Morgan Stanley Intl   New Japan Securities Europe Ltd   Nippon Credit Bank Intl (HK) Ltd   Nippon Kangyo Kakumaru (Europe) S.A.   Nomura Intl ltd   Orion Royal Bank Ltd   Sanwa Bank (Underwriters) ltd   J. Henry Schroder Wagg & Co. Ltd   Societe Generale   Societe Generale de banque S.A.     Sumitomo Finance International   Taiyo Kobe Bank (Luxembourg) S.A.   Tokai bank Nederland N.V.   Union Bank of Switzerland (Securities) Ltd   Wako International (Europe) Ltd   Westdeutsche Landesbank Girozentrale   Wood Gundy Ltd   Yamaichi Intl (Europe) Ltd 

 
Circumvention of regulation is the source of many innovations that are not what they seem at first glance. An example is the yen-linked Eurobond issued by Japan Air Lines in the mid-1980s and illustrated in Figure 2. This deal was done when the Japanese capital market was more protected than it is now. Foreign borrowers were not allowed into the domestic bond market, and all domestic yen bonds were subject to a withholding tax of 15%. Japanese firms were not permitted to issue yen-denominated Eurobonds, although they were, with Ministry of Finance approval, allowed to issue Eurobonds denominated in other currencies.

JAL wished to save money by issuing a Eurobond, free of withholding tax, on which it would pay a lower rate than one subject to the tax. But it wanted yen, not dollar financing. The currency swap market did not yet exist. So JAL issued a dollar-denominated Eurobond which repaid a dollar amount equivalent to ¥2.8 billion. In effect, the principal redemption was yen-denominated. But the interest was also yen linked, for as the tombstone suggests the coupon paid was a fixed percentage, 7 7/8%, of the yen redemption amount. So for all intents and purposes, it was a yen bond; but it satisfied the letter of the law in Japan, and did so with the approval of officials at the Ministry of Finance, who were in effect giving selected Japanese companies a back-door feet-wetting in the Euroyen bond market. (The fact that the JAL deal was officially sanctioned is evident from the name of the guarantor, and from the veritable who's-who of international investment banking listed as underwriters.) In due course the front door was opened, and later the withholding tax removed. This illustrates the reality that many regulation-defying innovations are undertaken with the explicit collusion of the regulatory authorities who may be unable or unwilling to remove the regulations themselves.

Tax-Driven Innovations. The tax authorities are usually much less willing to give in than the regulatory authorities, so innovators must stay one step ahead of the game for the innovation to survive. (Sometimes, however, the tax authorities will not fight to close a loophole because they recognize that the loss of firms' competitive position will mean minimal tax gathered relative to the cost of more vigilant enforcement. Such was the case with the U.S. withholding tax on corporate bonds issued in the United States and sold to non-residents. American companies found that they could avoid the withholding tax by issuing Eurobonds offshore and channelling the funds back home via Netherlands Antilles subsidiaries, and the Internal Revenue Service did not close that loophole for it was unlikely that foreigners would otherwise have bought the domestic bonds and paid the 30% withholding tax.)

All Eurobonds are designed to be free of withholding tax, and many have additional features that offer tax advantages to issuers as well as investors. An example of the latter is certain breeds of the perpetual floating rate note which give issuers an approved form of capital, in effect preferred stock, but with the interest (and in rare cases even the principal) being tax deductible.

Another technique that has enjoyed many years of success is money market preferred stock, also called auction rate preferred. Preferred stock pays a fixed dividend in lieu of interest, and investors get preference over common shareholders, but the dividend can be reduced or skipped if earnings are insufficient. Under the tax laws of most countries interest is tax deductible while dividends are not. But in some countries, notably the United States and Great Britain, corporations owing shares in other corporations are only partially taxed on dividends received. So if one U.S. company (A) issues preferred stock to another company (B), B is taxed at a reduced rate on the dividends paid on the preferred, but A cannot deduct the payments from taxes owed. So companies with zero tax liabilities often issue preferred stock instead of straight bonds.

A mutation of conventional preferred stock is money market preferred stock, issued with short effective maturities of (typically) seven weeks. The investor is told what the expected dividend will be, but of course has no guarantee that it will be paid at all given that he is buying shares. So the investment banker arranging the deal holds an auction at the end of every seven weeks, replacing the existing investors with new buyers. The new dividend to be paid is raised or lowered in the auction process such that the money market preferred is priced at par, at one hundred cents on the dollar. Typical language in the prospectus might be: "At an initial dividend rate of 4.50% per annum with future dividend rates to be determined by Auction every seven weeks commencing on [date]." So the investor gets all his principal and interest, just as though he had purchased commercial paper or some other money market instrument. Although the rate paid is lower than comparable money market instruments, the effective after-tax return is higher. For the borrower who does not need the tax deduction that conventional interest offers, this has proven to be a low-cost way of financing.
 
 

This announcement appears as a matter of record only

NEW ISSUEFEBRUARY 1990 

KB
 

KREDIETBANK INTERNATIONAL

FINANCE N.V.

(Incorporated with limited liability in the Netherlands Antilles)

¥3,000,000,000

13.5 per cent. Guaranteed Nikkei Linked Notes

due 1991

unconditionally and irrevocably guaranteed by

KREDIETBANK N.V.

(Incorporated with limited liability in the Kingdom of Belgium)

Issue Price 101.125 per cent.

New Japan Securities Europe LtdBankers Trust International Ltd 

Daewoo Securities Co., Ltd.IBJ International Ltd 

Kredietbank N.V.Mitsui Trust International Ltd 

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        Constraints
Constraint-Driven Innovations. Not all market imperfections stem from government regulations and taxes; some are self-imposed, taking the form of trustee rules or standards set by self-regulatory organizations. For example, many institutional investors promise to invest only in instruments below a certain maturity or only in "investment grade" bonds, meaning those rated BBB (or equivalent) and above.

One common constraint is the institutional investor's ability to buy and/or sell options, swaps or other derivatives. When an important category of investor desires the revenues that option writing provides, or the protection-plus-opportunity that options buying offers, there is an opportunity for an investment banker to devise a security that incorporates the sought-after strategy into a specially tailored security. The embedded option or other derivative is often then "stripped out" of the instrument by the same (or a collaborating) bank. Such was the case with Nikkei-linked Eurobonds, which were issued in droves in the 1980s and 1990s. Here's how they worked.



Case Study

Figure 3 reproduces the announcement of a Nikkei-linked Eurobond issued by Kredietbank, one of Belgium's largest commercial banks. Why would a bank whose principal business is in Europe borrow three billion yen, and why linked to the performance of the Japanese stock market as measured by the Nikkei index?

The answer is arbitrage. Kredietbank, together with its advisors Bankers Trust and New Japan Securities, is taking advantage of a constraint on certain Japanese institutional investors, namely their inability to sell options directly. Japanese institutional investors have frequently sought higher coupons than are available in conventional Japanese bonds, and have been willing to take certain risks to achieve this goal. For many years one risk deemed acceptable by Japanese investors was the risk that the Japanese stock market would plummet. The market had achieved gain after gain and it looked like there was no turning back. Some institutions were therefore willing to bet that the market would not fall, say, more than 20% from its then current level. At the time the Kredietbank deal was done, in 1990, the Nikkei index had soared to 38,000. Given these conditions, a typical structure for a deal like this one was as follows.

First, as is sketched out below, a Japanese securities firm like New Japan Securities identifies investors, such as Japanese life insurance companies, who are interested in a high coupon investment in exchange for taking an tolerable risk on the Japanese stock market. The risk they are willing to take is equivalent to a put option: they will invest in a note whose principal will be reduced if, and only if, the Nikkei index declines below 30,400.

Kredietbank
[1]

¥13.5% Fixed

(6.3% above normal)

d

b

Implicit 1-year put option on Nikkei index

[2]

Japanese institutional investors
[3]

US$

Floating

L-d%

om
[3]

¥ Fixed

[4]

Kredietbank sells

 o1-year put option on Nikkei index

 
Bankers Trust
[5]

BT sells 1-year put option on Nikkei index

d

US institutional investor with portfolio of Japanese stocks
 
Simultaneously, capital markets specialists at the London subsidiary of Bankers Trust identify a bank who is willing to consider a hybrid financing structure as long as the exchange risk and equity risk are removed and the financing produces unusually cheap financing. This bank is Kredietbank, whose goal is to achieve sub-LIBOR funding. Bankers Trust will provide a swap that will hedge Kredietbank against any movements of the yen or the Nikkei index. Specifically, Japanese institutional investors such as life insurance companies will pay Kredietbank ¥3 billion for a 1 year note paying 13.5% annually ([1] in the diagram). This is 6.3% better than the current 1 year yen rate of 7.2%. At maturity the note will repay the face value in yen unless the Nikkei falls below 30,400, in which case the principal will be reduced according to a formula such as the following:

where X is the number of options sold by the Japanese life insurance companies to Kredietbank in exchange for the coupon subsidy [2]. The higher is X, the greater the subsidy that can be paid.

Kredietbank first changes the yen received into dollars. It then enters into a yen-dollar currency swap with Bankers Trust in which Kredietbank will pay (say) LIBOR-3/8% semi-annually, and, at the end, the dollar equivalent of the initial yen principal [3]. For example, if the spot rate is ¥135 per dollar, then Kredietbank receives the sum of $22,222,222 (=¥3,000,000,000/(135¥/$)) at the outset, pays half of LIBOR-3/8% of this sum each six months, and pays the same sum at the end.

In return Bankers Trust pays Kredietbank the precise yen amounts needed to service the debt, namely 13.5% of ¥3,000,000,000 at the end of each year and the principal amount as defined by the formula above, at maturity [4]. If the Nikkei happens to fall below the "strike" level of 30,400 then Bankers Trust, not Kredietbank, reaps the benefit.

Bankers Trust sells the potential benefit to a third party, such as a U.S. money manager seeking insurance against a major drop in the value of its portfolio of Japanese stocks [5]. The U.S. buyer of the Nikkei put pays Bankers a premium that exceeds the "price" the Japanese investor received by a comfortable margin, leaving enough to subsidize Kredietbank's cost of funds and leave something on the table for the investment bankers.

Although Bankers Trust and New Japan Securities might normally earn some fees from co-managing a ¥3 billion private placement such as this one, the real "juice" in the deal comes from the pricing of the option, the put option on the Nikkei index, that is embedded in the note. A key factor in making deals like this work is adjusting the interest rate and the principal redemption formula so as to leave everybody satisfied.
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Segmentation-Driven Innovation. Academics have long debated whether securities tailored to particular investment groups can actually save issuers money, or whether supposed advantages are eventually arbitraged out. The huge volume of CMOs4 in the United States seem to favor those who argue that splitting up cash flows to meets particular groups of investors' needs and views does provide value added. These instruments, some of which take the form of Eurobonds, divide the cash flows from mortgage pools into tranches based on timing of principal redemption (for investors with different maturity needs) and, in some cases, segregate the interest from the principal.

Distinct market segments of several kinds seem to exist in the international financial markets. Many investors, of course, have a strong currency preference. Credit risk problems prevent the majority of these from doing swaps and forwards themselves to arbitrage out differences. Some view a currency as risky in the short term but stable in the long term; it is for these that the dual currency bond was invented. The example that follows shows how these work.

Example

Dual currency bonds pay interest in one currency and principal in another. The interest rate that they pay lies somewhere between the prevailing rates in the two currencies.

For example the Sperry Corporation, through a Delaware financing subsidiary, issued a US$56 million dual currency bond in February, 1985. The interest rate, payable annually in dollars, was 6 3/4%. The principal, however, was equal to 100 million Swiss francs. The final maturity was February, 1995.

The spot exchange rate at the time was SF1.7857 per US dollar, making SF100 million equivalent to $56 million. The 10 year US dollar and Swiss franc interest rates at the time were 9.1% and 6.2 %, respectively, for comparable single currency bonds. 

How was the interest rate on the Sperry bond set? One can estimate the "correct" rate as follows. Recognizing that Sperry probably hedged the principal to be repaid in 10 years, we need the Swiss franc/ US dollar 10-year forward exchange rate to see what the repayment really cost Sperry. From interest rate parity, the forward rate can be calculated as follows:

From this, Sperry's dollar repayment amount is SF100,000,000/1.3640=$73,315,169. So Sperry repays $17,315,169 more than it borrowed. Expressed as an annual annuity, this is $1.134,258. This is 2.03% of $56 million, so the theoretical rate should be 7.07% 

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Asset-Backed Securities in Turkey

The Turkish Capital Markets Board has aggressively sought to modernize the country's capital market, and in 1992 it pushed though a decree that enabled Turkish banks to securitize certain assets.

The first such deal was done by a privately-owned bank, Interbank, which issued TL4.25 billion in securities backed by its leasing receivables. The issue had maturities of one to 10 months and bore an interest rate of 72.36 percent. At the time, one year bank deposits paid about 70 percent and three month deposits about 62 percent. Other institutions, such as Pamukbank and Yapi ve Kredi, followed with issues backed by consumer credits, mortgages, export receivables and other assets.

In these deals and ones like them, the assets are sold to a special purpose company which finances the purchase with a cushion of equity (provided by the sponsor) and a public debt issue or issues. Conditions for them to work include protection of the issuer from additional taxes, accounting and regulatory treatment that allows the sponsor to take the assets off its balance sheet, and protection for the investor including proper isolation of the assets' cash flows from the condition of the sponsor. The debt being issued typically has sufficient "overcollateralization" by the assets to achieve an investment grade rating.(9.10%-2.03%). The difference between the actual rate paid and the theoretical rate is Sperry's savings, assuming our calculations are correct. In point of fact the forward rate is unlikely to conform precisely to interest parity and there are additional costs to a deal like this so Sperry's savings would be smaller.

Nevertheless it is clear that in this deal as in many of this kind the investor is receiving less than the theoretical rate. Why? For the issuer to tailor a bond to investors' needs and views, there must be some cost savings. And the investor cannot replicate such structures directly, for small investors would never be able to enter into a 10 year forward contract.
 

Securitization of mortgages, car loans, credit card receivables and other assets with predictable cash flows represents a whole category of segmentation-driven innovation that is becoming more prevalent outside the United States--in Britain, for example, and in the Euromarket, and even in developing countries such as Mexico. The box describes the use of the technique in Turkey.
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Understanding New Instruments: The Building Block Approach

In this section and the next we offer two related approach to the analysis of hybrid instruments such as the ones discussed above.

A number of attempts have been made to categorize new financial instruments. Some class them by interest rate characteristics--fixed, floating or floating capped, for example. Others seek to divide them by rating, or maturity, or equity-linkage, or tax status. The Bank for International Settlements in a classic study categorized innovations according to their role: risk transferring, liquidity-enhancing, credit-generating and equity-generating.

The best way to group instruments depends in large part on the purpose for which the grouping is being made. The building block approach is used to learn how to construct or reverse engineer existing or new instruments. The idea is not so much that the reader will necessarily learn much new about instruments that exist now, but rather to develop a method that can be applied to new instruments as they appear.

The premise of the building block approach is that hybrid instruments can be dissected into simpler instruments that are easier to understand and to price. Many, although by no means all, hybrid securities can be broken down into components consisting of:
Bonds (creditor (long) or debtor (short) positions in zero coupon bonds)
Forward contracts (long or short forward positions in a currency, bond, equity or commodity)
Options (long or short positions in calls or puts on a currency, bond, equity or commodity)
The building block approach is to combine two or more bonds, forwards or options to create the same cash flows as some more complex instrument. A simple example: a coupon-paying bond is simply a series of zero-coupon bonds equal to the interest and a larger zero at the end equal to the principal. Arbitrage should ensure that the price of the coupon bond equals the sum of the prices of all the little zeroes. Another example: a zero coupon bond in one currency, plus a forward contract to exchange that currency for another, is the same as a zero coupon bond in the second currency.

We have already encountered a number of applications of the building block approach without calling it that. Chapter 7 showed how a futures contract can be broken into a series of repriced forward contracts. In Chapter 13 we learned that a currency swap is equivalent to a fixed rate bond in one currency and a short position in a floating rate note in another currency. And in Chapter 15 we constructed commodity price linked instruments from conventional bonds and forward contracts on commodities.
 

Let us illustrate how the building block method lets one better judge the value and pricing of a hybrid instrument than more ad hoc approaches by decomposing a callable bond into its components. Discussions by brokers with their investor clients often focus on the yield to maturity versus the yield to call of a callable bond. They like to point out when a callable bond appears superior to a non-callable bond when judged by either criterion. As Figure 4 illustrates, however, the investor cannot judge a callable bond by either or even both measures of return. Whichever way rates move, the investor gets the worst of both worlds, and should be compensated fairly for this risk. The way to judge the fairness of the bond's pricing is not by looking at yield but rather at the value of the components, and then comparing them with the investor's practical alternatives given his or her needs, constraints and views.


So to better evaluate and compare different callable (and non-callable) bonds, decompose the bond into

(1) Noncallable bond (bought by the investor)

and

(2) Call option (sold to the issuer by the investor)

Find the value of each component, to discover whether the composite bond is overpriced or underpriced relative to the investor's realistic alternatives. One method for doing so is as follows:
 
1. Use the market yield on similar noncallable bonds to find the value of the straight bond.

2. Subtract the price of the callable bond from the value of the non-callable bond to find the price received for the call option.

3. Compare that with the value the investor could have received from selling call options in the market (may use option pricing model), or compare it with the implicit value of call options embedded in other callable bonds from comparable issuers currently available in the market.


Another practical application of the building block method is in the decomposition of so-called inverse floating rate notes, also known as reverse floaters or yield curve notes.5 These instruments have been issued in large numbers in the United States, Germany and elsewhere during the past decade.
 
 

Example
In February 1986 Citicorp issued a $100,000,000, five-year Eurobond which it termed "adjustable rate notes." The deal had the following features, as described in the preamble to the prospectus:

Interest on the Notes is payable semiannually on February 27 and August 27 beginning August 27, 1986. The interest rate on the Notes for the initial semiannual interest period ending August 27, 1986 will be 9.25% per annum. The Notes will mature on February 27, 1991 and will not be subject to redemption by Citicorp prior to maturity.

So far so good. It's a 5-year non-callable note with a generous first coupon (6 month rates at the time were in the region of 8c%). The preamble went on to say that

The interest rate for each semiannual interest period thereafter, determined in advance of the interest period as set forth herein, will be the excess, if any, of (a) 17d% over (b) the arithmetic mean of the per annum London interbank offered rates for United States dollar deposits for six months prevailing on the second business day prior to the commencement of such interest period.

This is a lawyer's way of saying that the notes pay 17d%-LIBOR, but never less than zero.

Let's reverse engineer this. Seeing an instrument paying the difference between two rates reminds one of a swap. Indeed part of this instrument is like an interest rate swap and part is a bond (after all the investor is lending money). To replicate the cash flows of the Citicorp note,
 

(1) Buy a 5-year fixed rate bond paying 8.6875% (17.375/2), and

(2) Enter into a 5-year swap where you receive fixed 8.6875% and pay LIBOR.


You'll now receive 17.375% minus LIBOR every 6 months. But one more thing: you'll never have a negative payment under the Citicorp deal, so to mimic it you should also
 

(3) Buy a an interest rate cap at 17.375%. This pays the difference between LIBOR and 17.375% should LIBOR exceed that level. It's deep out of the money so it's cheap.


These three transactions precisely replicate the cash flows of the Citicorp inverse floating rate note. Now you are in a position to evaluate the Citicorp note against other investments. If the five-year bond yield (and by implication the swap rate) exceeds 8.6875% (as it did in February 1986) by a sufficient amount, it may be worthwhile replicating the instrument rather than buying it. For example, if the bond and swap rates were 9%, transactions (1) and (2) would reap 18% instead of 17.375%. In reality most individuals and money market investors who might purchase a reverse floater do not have access to the swap market and/or may not be permitted to hold fixed-rate bonds, so this deal may look better even if its pricing is such as to give Citicorp cheap financing. Even so, the autopsy can serve a purpose: one realizes that the effective duration of this instrument is that of two five year bonds, minus a six month instrument, unlike other floating rate notes (which typically have a duration of .5 or less). So it has a high degree of price risk.

 
The last point in the example above--the price risk factor--may be more important than knowing how to duplicate the instrument. Moreover many new financial instruments, such as those with prepayment options that are contingent on corporate events rather than on interest rate conditions--are not easily broken down. For these one may need complex option-based models. Both considerations suggest that sometimes a price-based analytic approach may be more useful.
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Hedging and Managing New Instruments: The Functional Method

This section describes a second approach, which we may term the functional method, to the analysis of hybrid or complex securities. Its aim is not dissection, for one cannot always break instruments down for practical purposes, but rather to describe the price behavior of any hybrid bond or other instrument. The method helps to show which instrument serves precisely what purpose for particular investors or issuers. The method can also be used to create optimal hedges or arbitrages for one instrument against another.

The premise of the functional approach is that for practical purposes the only thing that matters about an international bond or other instrument is changes in its value--in its market price, if it is tradeable. Although one does not always think of a bond this way, in the final analysis one seldom cares more about a bond's beauty or soul than about its market value.

The key idea of the functional approach is that the value of every financial instrument can be characterized as a function of a set of economic variables. These variables might be ones such as the three-month US Treasury bill rate or the dollar-sterling spot exchange rate, or the Financial Times sub-index of consumer electronics stocks or the price of an individual company's stock. The presumption is that each instrument's payouts are contractually linked to the values or outcomes of a set of variables or events. If it is true that we can in principle express the value of every financial instrument as a function of a set of known variables like those listed above, then it seems that in order to understand what an instrument does, and what it's good for, and how its price behaves under different scenarios, we have to know three things:
 

The precise variables or factors that have the most effect on the instrument's price, and
The functional relationship that shows how a given movement in each variable's value translates into changes in the instrument's value, and
The relationship between the factors--whether, in particular, specific factors are positively, negatively or nor at all correlated with each of the other significant factors.
Example
Consider an example: a two-year Euroyen bond. Our task is to describe, as fully as possible, its price behavior in US dollars. We will attempt to do so in three stages.

1. Identify the variables

Yen-dollar exchange rate, since we are interested in the dollar price of the bond.
2-year Japanese interest rate on an equivalent bond.
1-year Japanese interest rate (since coupons are paid annually in the Euroyen market, the bond's value will be affected by the present value of the first year's coupon).
2. Describe the functional relationship between the bond's price and the set of key variables. Here's where the building block approach can be helpful: the valuation of the components of the security may yield the valuation of the hybrid instrument as a whole. In the case of the US dollar value we can say it is the present value of the cash flows in yen, all translated into dollars at today's spot exchange rate:
 


where P is the price of the bond, SPOT the dollar/yen spot exchange rate and R the US interest rate used to discount cash flows.

3. Estimate the correlation among the variables. We cannot fully understand the influence of any one variable on the bond unless we know whether that variable is independent of the others. Japanese interest rates of different maturities are highly correlated, and probably inversely related to the yen-dollar spot exchange rate (yen per dollar). In real life we have to make approximations. For most purposes it would probably suffice to ignore the interest rate-exchange rate relationship (a poorly understood one at best), and assume that the 1-year and 2-year Japanese interest rates move perfectly in tandem.

This allows us to simplify the relationship and to use the duration concept to show the sensitivity of Euroyen bond prices to 2-year Japanese interest rates. We then simply translate the price change into the US dollar value at the spot exchange rate, giving the dollar price change in the Euroyen bond.

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Application: Valuation of an Oil-Linked Bond

The functional method requires a model for valuation of the instrument. This is not always easy to devise with precision. In this section we describe an effort to value a bond with embedded long term options on the price of oil. The oil-linked bond was issued by Standard Oil of Ohio Company at the end of June 1986. The bond represented $37,500,000 face value of zero coupon notes maturing on March 15, 1992. The holder of each $1000 note was promised par at maturity plus an amount equal to the excess, if any, of the crude oil price (West Texas Intermediate) over $25, multiplied by 200 barrels. The limit for the WTI price was $40, so that the maximum the investor could receive at maturity was ($40-$25)x200=$3000, plus the par value of $1000. In addition, each holder could redeem his or her note before maturity on the above terms on the first and fifteenth of each month beginning April 1, 1991.

For the purposes of calculating the settlement amount, the oil price was defined as the average of the closing prices of the New York Mercantile Exchange light sweet crude oil futures contract for the closest traded month during a "trading period" defined as one month ending 22 days before the relevant redemption or maturity date.

Let us decompose the Standard Oil issue. Each note can be regarded as a portfolio consisting of :

(a) a zero-coupon corporate bond, plus
(b) one quasi-American" call option with an exercise price of $25, plus
(c) a short position in one quasi-American call option with a $40 exercise price.
The "quasi-American" feature results from the intermittent early exercise right in the last year of the bond's life.
Making some simplifying assumptions, Gibson and Schwartz have been able to develop a valuation model for this bond and to test it using actual trading prices for the issue. The model was based on arbitrage-free option pricing principles; the data were actual (but infrequent) transaction prices of the bond over the period August 1, 1986 to October 14, 1988. Transaction prices were used in preference to bid and ask quotations since the spread was too wide, averaging 10% of the bid price. Gibson and Schwartz found that the key variables in the valuation of oil and similar commodity linked bonds were the volatility and the convenience yield.

On its own, the function or formula helps price the instrument and can be used for sensitivity analysis in, say, portfolio management. But its chief value is in combination with similar analysis applied to other instruments. As long as there is some overlap in the functional variables, we can perform comparative analysis to show the price behavior of a combination of instruments--for hedging or arbitrage purposes, or to identify the most effective way of positioning in a particular market. The box gives an example.
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Hybrids in Corporate Financing:

Creating a Hybrid Instrument in a Medium Term Note Program

Hybrid instruments, we have seen, are widely used by corporations and banks in financing. Among the most versatile of instruments for the design and issuance of hybrid claims is the medium term note, for the distribution technique of MTNs lends itself to being tailored to one or a few specific investors. This section will describe the design and use of a hybrid instrument that was used by a major European bank as part of its funding. The names have been disguised but the sequence of events and the technique itself are close to the original.

The story begins in Munich, where Bavaria Bank has its headquarters. To help meet its ongoing funding requirements the bank recently set up a medium term note program of the kind described in Chapter 10. The program was managed by EuroCredit, an investment bank in London.

EuroCredit, the intermediary, is a well established and experienced bank in the Euromarkets. Its staff has the technical and legal background needed to arrange structured financing, and has trading and positioning capabilities in swaps and options--a "warehouse". Its underwriting and placement capabilities lie not so much in the capital it has to invest in a deal, but rather in its relationships with investors and with corporations, banks and government agencies that use over the counter derivatives. Indeed with recent economic conditions portending a rise in interest rates, EuroCredit has perceived mounting interest in caps, swaptions and other forms of interest rate protection. EuroCredit has a high credit rating, making it an acceptable counterparty for long term derivative transactions. These capabilities make it suited to the creation of hybrid structures for financing.

An official of EuroCredit described the background to the deal :

"The issuer, Bavaria has excellent access to the short term interbank market, but was seeking to extend the maturity of its financing. It was looking for large amounts of floating-rate US dollar and German mark funding for its floating-rate loan portfolio.

It had set a target for its cost of funds of CP less 10, in other words the Eurocommercial paper rate minus .10%. Because its funding needs were ongoing and any new borrowing would replace short term interbank funding, it was not overly concerned with the specific timing of issues, or the amount or maturity. This flexibility made a medium term note program the ideal framework for funding. Best of all, Bavaria was willing to consider complex, hybrid structures as long as the bank was fully hedged.

"We have a standard sequence of steps that we follow for borrowers of this kind [see box]. What we now needed was to identify an investor or investors for whom we could tailor a Bavaria note.

"An institutional investor client of ours, Scottish Life, has a distinct preference for high grade investments, so Bavaria's triple-A rating brought them to mind. They have been on the lookout for investments that would improve their portfolio returns relative to various indexes and to their competition. An initial discussion with them revealed that they invest in both floating rate and fixed rate sterling and US dollar securities. Like other U.K. life insurance companies, they are constrained in certain ways; in particular, they can buy futures and options to hedge their portfolio but they cannot sell options."

The stage was now set for EuroCredit to arrange a note within its medium term note program, one designed to meet Scottish Life's needs and constraints, and to negotiate the terms and conditions with the various parties.

The deal that emerged was a US dollar hybrid floating/fixed rate note paying an above-market yield in which Bavaria had the right to extend the maturity from 3 years to 8 years. "Although it was a really private placement," said the EuroCredit official, "we wrote it in the form of a Eurobond with a listing in Luxembourg. This was to meet Scottish Life's requirement that it only buy listed securities."

The following "term sheet" summarizes the main features of the note.

ISSUER:
Bavaria Bank AG
AMOUNT:
US$ 40 MILLION
COUPON:
First 3 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:
EuroCredit Limited
 
The crucial elements are the coupon and call clauses. First, to appeal to the investor, the issuer has agreed to pay an above-market rate on both the floating rate note and the fixed rate bond segments of the issue
 
FRN portion:  .75% above normal cost

Fixed portion:  .50% above normal cost


But by having the right either to extend the issue or terminate it after three years, the 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. Through its investment bank, the issuer will sell this right for more than it cost him, and so lower his funding cost below normal levels. This is illustrated in the following diagram.

BAVARIA

BANK

Bavaria
sells 3 year floating rate note paying LIBOR-d%

d

For an additional ¾% pa, Bavaria buys right to sell 5 year fixed rate 8.35% note to SL in 3 years

b

SCOTTISH

LIFE

o
For 1% pa, Bavaria sells EuroCredit a swaption (the right to pay fixed 8.35% for 5 years in 3 years)
 
 
EUROCREDIT
EuroCredit sells the swaption to a corporate client seeking to hedge its funding costs against a rate rise
 
 
One could argue that Scottish Life would have been better off selling the swaption directly to EuroCredit or even to EuroCredit's client. This is not realistic: the institutional investor is not permitted to write options directly, although as is typical it is permitted to buy callable bonds and other securities with options embedded. Moreover it may not have a sufficient credit rating to enable it to sell stand-alone long term derivatives at a competitive price.

These constraints are necessary but not sufficient conditions for a hybrid bond such as the one described to become reality. The characteristics of the intermediary are often underestimated. Not only must it have the "rocket scientists" who can devise and price complex options, but it must also be able to trade and position them so as to be able to offer a deal quickly rather than having to wait around for a buyer of the derivative before the deal can be consummated. It must have excellent institutional investor relationships preferably in places "where the money is" like the United States, Germany and Japan. Insight into institutional and corporate needs and constraints is a scarcer commodity than a Ph.D. in physics from Moscow State University. The financial institution must have experience and credit and people that can be trusted. Few banks qualify.
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Structured Financing
Structured Financing: A Sequence of Steps

 The following sequence of seven steps gives an indication of how investment banks arrange specially-structured financing, often tailored to investors' requirements, in the framework of a medium term note program.

 1. Initiate medium term note program for the borrower, allowing for a variety of currencies, maturities and special features

 2. Structure a MTN in such a way as to meet the investor's needs and contraints

 3. Line up all potential counterparties and negotiate numbers acceptable to all sides

 4. Upon issuer's and investor's approval, place the securities

 5. For the issuer, swap and strip the issue into the form of funding that he requires

 6. Sell the stripped-off derivative to a corporate or investor client that requires a hedge

 7. Offer a degree of liquidity to the issuer by standing willing to buy back the securities at a later date.

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Global Financial Markets in the Next Decade

Nobody knows for sure what the future holds. Even so, the practitioner and observer of global financial markets can be confident that innovation and adaptation of instruments will continue. This and some of the conclusions reached in earlier chapters allow us to venture a few predictions.

First, the structure of individual economies, and of the world economy, is in a state of change. As a result there is a great challenge for creativity in international financial techniques to with the problems of, among others, (1) the changing demographic composition of the industrial countries, (2) the emerging capital markets, (3) developing economies that lack adequate domestic financial markets and banking systems, and (4) the once-socialist economies in transition.

Second, as new countries compete more vigorously with the old, the existing order will break down. This means that any financial institution resting on its laurels will come under great competitive threat, and to survive and thrive must change in response to the new order--whatever it is.

Third, global and regional monetary arrangements such as the European monetary system will continue to be in flux for some years to come. Few believe that unfettered freely-floating exchange rates will eliminate adjustment problems. Multi-year deviations from purchasing power parity will persist. Yet countries seeking the discipline of fixed exchange rate arrangements will have to contend with the strains in money and currency markets that accompany an attempt to fix exchange rates before economic policies are unified.

Fourth, in the light of these economic changes and pressures, investors, banks and broker-dealers must vastly upgrade their understanding of, and ability to manage, complex financial instruments, particularly option-based instruments such as those described in this and preceding chapters.

Fifth, with the erosion of barriers to international competition in goods, services and financial markets, there is an increasingly strong inter-relationship among money, bond, currency, commodity and equity markets, and between the derivative markets in each of these categories.

Sixth, despite the preceding statement, academic and practical understanding of exchange rate determination, and of the determination of equity prices in an international context, is still in a state of flux. For some years to come the jury will be out on some of the theories propounded in this book, as well as on the ones that inevitably replace them.

Finally, policy-makers will face severe demands at the micro as well as at the macro level. Bank and securities market regulators have a long road to tread in developing credible standards for credit risk and market risk control, as well as for disclosure requirements. On the other hand with banks losing their privileged positions, any increase in regulatory costs inserts a wedge between investors and borrowers, driving companies and individuals to foreign or offshore markets.

In short, neither regulators nor practicing bankers nor academic scholars can afford to be complacent about the global financial markets in the decade to come.
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Summary and Conclusion

Financial innovations are challenging and fun. Most of the time they do not work. When they do, it is because they successfully overcome some market imperfection. This chapter has sought to help the reader understand the conditions that are necessary for hybrid securities to succeed as well as to learn their use as investment and financing vehicles.

Imperfections that drive innovations include transactions costs and the costs of monitoring performance, government regulations, taxes, constraints and market segmentation.

Most instruments of the international capital market can be broken down into simpler securities. These elementary securities or building blocks include zero-coupon bonds, pure equity, spot and forward contracts and options. Reverse financial engineering can be done to figure out how a hybrid instrument could be replicated using simpler instruments.

For many purposes what we want to know is how the instrument will behave given changes in the certain market variables. The functional method regards every such instrument or contract as bearing a price or value, which in turn bears a unique relationship to some set of variables such as interest rates or currency values. This can be complex, but the idea is simple and can be illustrated in the matrix below. To fill in the blank cells for a particular security, ask whether the instrument's value bears a forward-type (linear) or and option-type (kinked) relationship to the market variable, and what that relationship is.

A HYBRID BOND MATRIX

 
FORWARD-TYPE LINKAGE
OPTION-TYPE LINKAGE
INTEREST RATE
 
 
CURRENCY
 
 
COMMODITY
 
 
EQUITY INDEX
 
 
EQUITY OF COMPANY
 
 
 
As numerous examples in the chapter demonstrated, an analytical approach, even one that make simplifications for practical reasons, can be of great value to investors and issuers who wish to better understand the risks of instruments offered to them by banks. The approach can also be used to identify arbitrage opportunities between instruments, and to hedge one instrument with another.

Dissecting new financial instruments offers great challenges, and encourages a way of thinking that may help equip us to adapt to the significant changes in the world economy that are inevitable in the next decade.



Selected References

G. Dufey and Ian H. Giddy, "Innovation in the International Financial Markets" (with G. Dufey), Journal of International Business Studies (Fall 1981), 33-52.

Joseph D. Finnerty, "Financial Engineering in Corporate Finance: An Overview," Financial Management, Vol. 17, No. 4 (Winter 1988), 14-33.

Clifford W. Smith, Charles Smithson and D Sykes Wilford, Managing Financial Risk (Ballinger, 1990).

Julian Walmsley, The New Financial Instruments (John Wiley & Sons, 1988)

Risk Magazine, various issues.

Journal of Financial Engineering, various issues.
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Conceptual Questions

1. In choosing an investment bank to arrange an innovative, tax-driven lease financing bond issue, what strengths would you look for to minimize the chances of the deal going wrong?

2. Using current financial newspapers such as the Financial Times or the Wall Street Journal, or magazines such as Euromoney or Risk, identify two kinds of financial innovations: one that has lasted but become more competitive, and one that has been relegated to disuse by a change in regulations or taxes. Explain how the product innovation cycle has worked for each of them.

3. Many Eurobonds have been issued with equity warrants. A warrant is nothing but a long term, over the counter call option on the issuing company's shares. The warrant is separable from the bond, and tradable independently. What possible advantage might the issuer and/or investor obtain from packaging the two together?

4. Use the building block approach to dissect the Ford Motor Credit bond described in the following announcement

Ford Motor Credit Maximum Rate Notes

$100,000,000

10¾% Maximum Rate Notes due December 3, 1992

Interest on the Notes is payable semi-annually at a rate equal to 10.75% per annum; provided, however that if the arithmetic average mean of the London interbank offered quotations for six-month U.S. dollar deposits prevailing two business days before the beginning of any Interest Period exceeds 10.50%, then the rate for such Interest Period will be reduced from 10.75% by the amount of such excess.

5. In 1987 Sallie Mae issued currency linked bonds that were sold to U.S. individual investors. These bonds had the characteristic that the principal amount would rise if the US dollar value of the Japanese yen fell, and vice versa. Explain why Sallie Mae, a federal agency, would issue such bonds; and explain why investors would buy them.

6. Many hybrid financing techniques take the form of an option embedded in a bond which is bought by an investor and which is "stripped off" by the issuer. List the conditions necessary for such deals to work.

7. In Chapter 15 we learned about a copper-linked bond issued by the Magma Corporation. Use the functional approach to describe the price behavior of that bond. In other words, show how the value of the bond would be expected to change as interest rates, the price of copper, and the equity price of Magma change.

8. One of the examples in this chapter described a collared sterling floating rate note issued by the Leeds Permanent Building society. Show, by means of a diagram, what transactions would have to take place between Leeds and Salomon Brothers to allow this structure to give Leeds a below-market cost of funds. Also explain why this structure might work in a currency with a steep yield curve, but not in a currency where the yield curve is flat.



Problems

1. The EBRD (European Bank for Reconstruction and Development), as part of its funding in the Far East, has announced the issue of a ten year, dual currency ECU/Japanese yen bond. The coupon will be paid in yen at a semi-annual floating rate equal to the Euroyen interbank offered rate + 2%, expressed as a percentage of 18 billion yen. The final principal amount of ECU100 million will be repaid in ECU. The spot yen/ECU crossrate is ¥180 per ECU, and the 10 year swap rates are ECU: 10.10%, yen: 5.3%.
If you worked for a Japanese leasing company whose cost of funding was yen LIBOR +0.35%, would you buy this bond? What is its theoretical value?

2. What is the minimum price that Bankers Trust could charge its U.S. clients for the option or options embedded in the Nikkei-linked bond issued by Kredietbank described in the chapter?

3. In 1981 Exxon Capital Corporation N.V. (Netherlands Antilles) issued a 20 year US dollar denominated zero coupon Eurobond with a face value of $1.8 billion. The issue was priced to yield 10.7%, free of withholding tax, and issuance costs were 1.5%. At the same time twenty year US Treasury zero coupon bonds, subject to a 30% withholding tax, were trading at a yield of 11.6%. By taking advantage of the tax treaty between the United States and the Netherlands, Exxon Capital Corporation could invest in U.S. Treasuries without paying withholding tax. How much could Exxon earn on this arbitrage-based deal?

4. The Republic of Turkey issued a five year puttable bond in 1990. The bond paid 9.70%, only 45 basis points over the comparable US Treasury yield, and was puttable at 99 after 4 years.
If the yield curve was flat and the volatility of one year Treasury bill prices is estimated at 7%, what is Turkey's effective cost of funds?

5. The European Investment Bank, an official European Community institution, issued DM300,000,000 of floating rate notes in 1993, as described in the "tombstone" on the next page.
Explain how the notes work, and what the components or building blocks of the deal are. Also show, by means of a diagram, how the EIB could have hedged this to obtain fixed rate Deutsche mark financing.

EIB FRN tombstone. Source: Financial Times, March 4, 1993, p.18.
 
 


6.
Commonwealth of Puerto Rico

Variable-Rate Tax-Exempt Debt


Key Rates
in percent per annum
 
PRIME RATE
DISCOUNT RATE
FEDERAL FUNDS
3-MO TREAS. BILLS
6-MO TREAS. BILLS
7-YR TREAS. NOTES
30-YR TREAS. BONDS
TELEPHONE BONDS
MUNICIPAL BONDS
6.00
3.00
3.25
3.06
3.12
5.94
7.31
8.35
6.25
Puerto Rico, although not one of the fifty United States of America, enjoys Commonwealth status. As a result its general obligation bonds are exempt from federal, state and local taxes in the USA. In August 1992 the island took advantage of this to sell $538.7 million worth of fixed-rate and variable rate securities.

Of this total $343.2 million worth were conventional fixed rate bonds. Their maturities and yields were: 1994, 3.90%; 1997, 4.90%; 2002, 5.75%; 2006, 6.05%; 2009, 5.90%; and 2014, 6.25%.

The variable rate notes made up the remainder of the financing and comprised equal amounts of auction-rate notes and yield-curve notes. The auction-rate notes, which were privately placed, were short-term investments that would be repriced every fifth Thursday through a Dutch auction. If the results of these auctions produced a rate lower than a certain fixed rate, the difference was given to investors of the yield-curve notes, increasing their return. But if the Dutch auction produced a higher rate than that fixed rate, the difference reduced the yield on the yield-curve notes. In extreme cases the yield could be zero. The notes were insured by Financial Security Assurance, earning them a triple-A rating.

The yield curve notes, which matured in 2008, were sold out immediately, perhaps because their initial coupon was a generous 9.01% in a market starved for yield (see the table above for current rates).

1. Explain, with a diagram, how the auction-rate and yield-curve notes work.

2. What incentives would investors have to buy Puerto Rico's yield-curve notes?

3. What hedge, if any, would Puerto Rico need to protect itself against interest rate risk in conjunction with the issuance of these notes? Explain your answer precisely.

(Sources: New York Times, August 20, 1992, p. D15, and bond dealers.)


7.
A Call to Guernsey

You are the assistant manager of the international bond syndicate desk of Crédit Suisse in Zurich. The manager of a Trust in the Channel Islands telephones you. He is interested in investing in a US dollar denominated Eurobond, and wants to get a good yield. You tell him about some new issues that are available, but note that some of them are callable. He says that's okay, as long as he's getting good value for his money. He asks you to fax him a list of bonds currently available.

An hour later he calls you. He has studied the fax and identified three bonds that are satisfactory credits for his Trust and seem to offer decent yields. But he would like your advice in deciding which of the three offers the best value for money.

The three bonds are:

A 5-year Sony Eurodollar bond paying 9.1%, callable at 102 in three years.

A 5-year BASF Eurodollar bond paying 9.3%, callable at 101 in four years.

A 5-year SNCF noncallable Eurodollar bond, paying 8.7%.

All the bonds are priced at par. Please explain the method you would use to compare the value of the three bonds from the investor's point of view. To help you some information about conditions in the bond market and in the Treasury bond options market is given below.

March 24, 1991
U.S. TREASURY YIELD CURVES 
AA CORPORATE YIELDS
3 MONTHS

1 YEAR

2 YEARS

3 YEARS

4 YEARS

5 YEARS

10 YEARS

30 YEARS

5.97

6.28

7.09

7.32

7.55

7.76

8.07

8.26

6.30

7.40

7.67

8.04

8.44

8.72

 
US TREASURY BOND FUTURES 8%

$100,000 32nds of 100 

 
US TREASURY FUTURES OPTIONS - 64ths of 100
 
 
 
 
 
Strike
Calls Jun
Calls Sep
Puts Jun
Puts Sep
Jun Close
Sep Close
 
93
2-27
2-55
0-39
1-49
94-26
94-03
 
94
1-47
2-21
0-59
2-15
 
 
 
95
1-10
1-55
1-22
2-49
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8.
BIG

MEMORANDUM

TO: Andy Hubert,

SVP, U.S. Capital International

FROM: Jack Levant

DATE: September 1, 1987

SUBJECT: Brand International Gold
 

As discussed with you last week, we propose to raise a $100 million for Brand International Gold (a subsidiary of Brand Holdings), in the Eurobond market. U.S.C.I. would be co-lead manager with Soditec of Switzerland of a U.S. dollar denominated bullet bond plus gold call warrant package. London would run the books.

Kindly evaluate the proposed structure. Do you think Brand would bite? What is your judgment on potential investor appetite, based on similar deals that have been placed? Can you suggest any changes to the terms and conditions that would make the deal more palatable to issuer or investors?
 
 
 
 

Exhibit I. Proposed BIG Eurobond with Gold Warrants

The Bond

Guarantee: Guaranteed by parent company (Brand Holdings)
Size: U.S. $100 million
Maturity: 10 years
Coupon: 6.5% (annual)
Price: 100
Call Features: None
Ranking: Senior unsubordinated
Rating: Single-A rating will be sought
Collateral: Partially collateralized with U.S. gold mines (St. Joe Gold)
Each U.S. $1,000 bond will have two warrants attached. The warrants will be detachable after issue.
 

The Warrants

Commodity: 1 troy oz. gold
Strike: U.S. $500
Expiration: 3 year American

Advantages to the issuer:

* The issuer is paying a coupon substantially below that which would otherwise be available in the Euromarkets; he does this by foregoing some of his gain if gold rises.

Advantages to the investor:

* The investor is receiving warrants which have a strike price sufficiently close to the spot price for it to appear probable that the warrants will be in-the-money at expiration.
* Actually, when compared to the estimated forward price of gold, the warrants are about $186 in the money!
* The terms of the warrants are similar to those which have been launched recently in the Euromarkets (see Exhibit III).
* Gold warrants have predominantly been purchases by retail investors either seeking a "bet" on gold or an inflation hedge. In the Euromarkets such investors prefer to invest in corporations with a high credit rating. The guarantee is necessary to achieve an acceptable rating.
* By estimating the value of the warrants (see below) and subtracting that value from the $1,000 face value of each bonds, we can calculate the effective return on the naked 6½% bond. With ten year treasuries at 9% the effective bond return gives a spread of 400 b.p. which is in line (perhaps a little tight) with other AAA guaranteed bonds.

Valuation of the Warrants and Alternative Structures

Exhibit II shows our valuation of the package using a European option valuation model for the warrants and a cost-of-carry model for the price of the forward contract. The standard deviation is the volatility of the price of gold. The interest rate is that of three year treasuries. The "effective bond cost" is the cost of the bond to the investor if the warrants could be sold immediately after issue for the "gold call value". The "effective bond return" is the yield to maturity of a bond priced at the "effective bond cost". The "issuer's initial cost" is the yield to maturity of the issuer's cash flows including the cost of the guarantee. This ignores the potential costs of warrant exercise.

If this structure is deemed unsuitable, alternative structures could be devised by altering one or more of the following:

(1) coupon,
(2) guarantee,
(3) time to expiration of the warrants,
(4) strike price of the warrants,
(5) number of warrants per U.S. $1,000.

The effect of each of the variables on the issuer's cost, the effective bond return and the gold call value are detailed below:

Coupon: Changing the coupon has no effect on the gold call value. Increasing the coupon both increases the issuer's cost and the effective bond return.

Guarantee: Has no effect on the gold call value or the effective bond return. The guarantee would have an implicit cost to the parent company in the form of an additional contingent liability.

[Alternatively, BIG could seek a Letter of Credit from one of its banks. We estimate that an LOC from Australian National Bank would cost about 70 basis points.

The balance between coupon and the guarantee is important if the bonds are to be seen as tradable ex-warrant.]

Time to Expiration: As the time to expiration increases the gold call value increases, increasing the bond return but having no effect on the issuer's initial cost, because: (1) the time value increased, and (2) the forward price increases making the option more in-the-money. With investors often not fully valuing these elements it is perhaps advisable to keep the time to expiration relatively short.
Strike Price: As the strike price increases the gold call value falls decreasing the effective bond return but having no effect on the issuer's initial cost. Although the option is valued off the forward price investors often consider the spot price. Thus the balance between the strike and the spot, and the strike and the forward is important.
Number of Warrants: As the number of warrants increases the effective bond return increases. The gold call value and the issuer's initial cost are unchanged. However, the effect of warrant exercise upon the issuer's cost is increased.

Exhibit II. BIG Bond and Warrant Valuation

*************** BRAND GOLD WARRANT ***************

30-August-87

(ASSUMING TEN YEAR ISSUE)

========================================

-> BOND COUPON 6.50%
-> SPOT GOLD PRICE 456
-> FORWARD PRICE 586
-> STRIKE PRICE 500
-> TIME IN YEARS 3
-> INTEREST RATE 8.25
-> STD DEVIATION 17

-------------------------------------------

INTRINSIC VALUE (PV) $68.18 PER OZ.
GOLD CALL VALUE. $91.32 PER OZ.
ISSUER'S COST 6.56%
NUMBER OF OZ. GOLD PER BOND: 2.00
TOTAL VALUE PER $1,000 BOND: $182.65
EFFECTIVE BOND COST: $817.35
EFFECTIVE BOND RETURN 9.40%

Note: Assumed cost of the letter of credit: 40 basis points up front.

Exhibit III. BIG Bond: Comparable Gold Call Warrants In The Market

Exhibit IV. Excerpts From Saint-Gobain Prospectus
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Footnotes

1From Global Financial Markets by Ian H. Giddy. Houghton Mifflin., 1994. Copyright © 1994-2000 Ian H. Giddy.  Not to be reproduced without permission.

2In this instance another important factor is credit risk. A corporation buying a cap from a bank has to concern itself with the potential for default on the cap writer's obligations, so creditworthy banks will retain a disproportionate share.

3A uniquely international dimension of some of these warrant is that they are denominated in Swiss francs. A Swiss franc denominated warrant on a yen-denominated share is a form of the quanto option described in Chapter 8. It is difficult to hedge; indeed as far as I can ascertain none of the Japanese companies issuing such warrants sought to hedge them in a scientific fashion. Hence the contingent liability inherent in any issue of warrants was made more complicated by the currency factor.

4Collateralized Mortgage Obligations

5See Donald J. Smith, The Pricing of Bull and Bear Floating Notes: An Application of Financial Engineering," Financial Management, Vol 17, No. 4 (Winter 1988), 72-81.

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