Goldman, Sachs & Co.
Controllers University
Capital Markets Curriculum
Module 2: Session 5
Bond Structures: Calls, Puts, and Structured Notes
Alan L. Tucker, Ph.D.
631-331-8024 (tel)
631-331-8044 (fax)
tucker@mtaglobal.com
Copyright © 2000-2001
Marshall, Tucker & Associates, LLC
All rights reserved
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ALAN L. TUCKER, Ph.D.
Alan L. Tucker is Associate Professor of Finance at the Lubin School of Business, Pace University, New York, NY and an Adjunct Professor at the Stern
School of Business of New York University, where he teaches graduate courses in derivative instruments. Dr. Tucker is also a principal of Marshall,
Tucker & Associates, LLC, a financial engineering and derivatives consulting firm with offices in New York, Chicago, Boston, San Francisco and
Philadelphia. Dr. Tucker was the founding editor of the Journal of Financial Engineering, published by the International Association of Financial
Engineers (IAFE). He presently serves on the editorial board of Journal of Derivatives and the Global Finance Journal and is a former associate editor of
the Journal of Economics and Business. He is a former director of the Southern Finance Association and a former program co-director of the 1996 and
1997 Conferences on Computational Intelligence in Financial Engineering, co-sponsored by the IAFE and the Neural Networks Council of the IEEE.
Dr. Tucker is the author of three books on financial products and markets: Financial Futures, Options & Swaps, International Financial Markets, and
Contemporary Portfolio Theory and Risk Management (all published by West Publishing, a unit of International Thompson). He has also published more
than fifty articles in academic journals and practitioner-oriented periodicals including the Journal of Finance, the Journal of Financial and Quantitative
Analysis, the Review of Economics and Statistics, the Journal of Banking and Finance, and many others.
Dr. Tucker has contributed to the development of the theory of derivative products including futures, options and swaps, and to the theory of international
capital markets and trade. He has also contributed to the theory of technology adoption over the life-cycle. The Social Sciences Citation Index shows that
his research has been cited in refereed journals on over one hundred occasions.
As a consultant, Dr. Tucker has worked for The United States Treasury Department, the United States Justice Department, Morgan Stanley Dean Witter,
Union Bank of Switzerland, LG Securities (Korea), and Chase Manhattan Bank. Dr. Tucker holds the B.A. in economics from LaSalle University (1982),
and the MBA (1984) and Ph.D. (1986) in finance from Florida State University. He was born in Philadelphia in 1960, is married (Wendy) and has three
children (Emily, 1993, Michael and Matthew, both 1995).
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Introduction to Structured Notes
What are Structured Notes?
Structured notes are hybrid securities that combine elements of derivative
instruments with elements of straight debt instruments. Structured notes are a
subset of a broader class of instruments known as structured securities.
By combining straight debt with various forms of derivatives, it is possible to create
“debt-like” instruments (the notes) that contain equity-like components, dual
currency components, commodity components, and various option-like components.
The straight debt components include fixed rate debt and floating rate debt.
The derivatives components include options, forwards, and swaps, any one of which
can be written on interest rates, exchange rates, commodity prices, or equity
indexes.
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Introduction to Structured Notes
What economic function do structured notes serve?
Structured notes can be tailor-made to suit an amazing array of investor needs or
preferences while at the same time satisfying the needs of issuers, even when the
needs of the issuers differ significantly from the needs of the investors.
Thus structured notes make it possible to more efficiently connect the suppliers of
capital (i.e., investors) with the users of capital (i.e., investors). The efficient
allocation of capital is the primary function of the financial system.
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Introduction to Structured Notes
Who are the issuers of structured notes?:
While any user of capital is a potential issuer of structured notes, Government
Sponsored Enterprises (GSEs) have been the biggest issuers, followed by large
corporations. Banks too have been issuers, but often in the form of structured-notelike products, such as equity-linked CDs.
As one example, as far back as November 1994, The Federal Home Loan Bank
(FHLB), one of the largest U.S. issuers, had issued structured notes linked to over
175 indices or index combinations.
Other GSEs that are big issuers include FNMA, SLMA, and FHLMC.
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Introduction to Structured Notes
Why have structured notes become popular?:
Investors are drawn to structured notes for a variety of reasons. Their popularity
grew rapidly in the early 1990s in response, in part, to very low interest rates and
very attractive returns in other markets (particularly equities).
The desire to earn higher returns in a low-interest rate environment induces investor
to take on risks ordinarily associated with other asset classes.
At the same time, because many structured notes are issued by Government
Sponsored Enterprises (GSEs), they are perceived to have very low credit risk. It is
important, however, for investors to appreciate that the issuances of GSEs are not
(generally) backed by the full faith and credit of the United States, the way Treasurys
are.
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Introduction to Structured Notes
Another reason these instruments have become popular is that they can be structured
to offset (i.e., hedge) unique risks that an investor faces in other asset classes.
Finally, structured notes can allow an investor to play an unusual view: such as a
specific benchmark interest rate staying within a prescribed range, or a particular
currency or commodity rising in value, or even a flattening or steepening of the yield
curve.
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Introduction to Structured Notes
Who are the investors in structured notes?:
Structured notes are generally issued in minimum denominations that are
significantly larger than the minimum denominations for straight debt.
For example, the FHLB issues straight debt in minimum denominations of $10,000.
For its structured securities, the minimums are generally $100,000 and for some
issuances (generally more highly structured notes) the minimums can be as high as
$500,000.
These kinds of denominations suggest that investors consist, primarily, of institutions
and wealthy individuals. Indeed, many structured notes are sold through private
placements and can only be sold to qualified investors.
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Introduction to Structured Notes
Retail: Despite the fact that many structured securities are intended for sale to
institutional investors and wealthy individuals, some products--particularly those
issued in more recent years--have been offered in denominations that appeal to retail
investors.
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Introduction to Structured Notes
The Fed’s and SEC’s concerns:
During the Spring and Summer of 1994, several money market mutual funds--most
notably the Piper Jaffray MMF--suffered significant losses on some structured
securities that they held in their money fund portfolio.
The result of these losses was to cause the NAV of the fund to drop below $1.0. This
is called “breaking the buck” and is one of the worst things (from an investor
psychology perspective) that can happen to a MMF.
These losses led to heightened concern on the part of the Fed, the SEC, the Office of
the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).
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Introduction to Structured Notes
Types of Structured Notes (sampling only):
– Floating Interest Rate Structures:
• Straight Floaters
• Capped Floaters
• Collared Floaters
• Range Floaters
• Inverse Floaters
• CMT Floaters
• Dual Index Floaters
• Leveraged and Deleveraged Floaters
– Fixed Rate Structures
• Callable bonds
• Single Step-Ups
• Multi-Step Ups
• Dual Currency
– Equity and Commodity Linked Structures
• Equity Linked Notes (ELNs)
– coupon linked
– principal linked
• Commodity Linked Notes
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The Building Blocks: Options, Forwards, and Swaps
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Introduction to Structured Notes
It is the presence of embedded derivatives, often options, that give structured notes
their complexity. These difficult to understand and difficult to value instruments
make structured notes beyond the ability of many investors to fully understand.
We need to look at these derivative components before proceeding to an
examination of how structured notes are constructed.
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Introduction to Structured Notes
What is an option?
Options represent the right, but not the obligation, to buy some asset or
to sell some asset at a fixed price for a limited period of time.
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Introduction to Structured Notes
Calls and Puts:
Options fall into two basic groups, calls and puts. Each represents a class of
options.
Call options: Call options, or more simply calls, give their owner (holder) the
right but not the obligation to buy a specific quantity of some asset from the
option writer for a set period of time at a fixed price. The asset is called the
underlying asset, the set period of time is called the time to expiration or
time to expiry, and the fixed price is called the strike price or exercise price.
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Introduction to Structured Notes
Put options: Put options, or more simply puts, give their owner (holder) the
right but not the obligation to sell a specific quantity of some asset to the
option writer for a set period of time at a fixed price. The asset is called the
underlying asset, the set period of time is called the time to expiration or
time to expiry, and the fixed price is called the strike price or exercise price.
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Introduction to Structured Notes
Premiums:
At the time of purchase, the option buyer pays the option writer a sum of money
for the right that the option conveys. This sum represents the price paid for
the option and it is called the option premium.
After paying the option premium, the long has no further obligations.
Premium = intrinsic value + time value
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Introduction to Structured Notes
Intrinsic value of a September 130 IBM call
Intrinsic value
$10
$5
0
130
135
140
SIBM
Intrinsic value = max[S - X, 0]
S denotes the spot price of the underlying
X denotes the strike price of the option
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Introduction to Structured Notes
Intrinsic value of a September 130 IBM put
Intrinsic value
$10
$5
0
120
125
130
SIBM
Intrinsic value = max[X - S, 0]
S denotes the spot price of the underlying
X denotes the strike price of the option
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Caps, Floors, Collars, and Exotic Options
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Introduction to Structured Notes
Multi-Period Options:
Multi-period options were first introduced in the mid 1980s (around 1986). They came
about because the swaps desks1 recognized a new variation of the put/call parity
theorem.
It turns out that a long position in an interest rate swap is equivalent to a portfolio
consisting of a long position in a multi-period call option on an interest rate and a short
position in a multi-period put option on an interest rate.
Since most interest rates swaps were written on 6-month LIBOR2, the implied multiperiod options are options on LIBOR.
-------------------------1
2
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Swaps desks later became known as derivatives desks or DPGs.
This was especially true in the mid 1980s.
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Introduction to Structured Notes
The multi-period calls on interest rates were first sold to corporations that had issued
floating rate notes that paid LIBOR. When LIBOR went down, these corporations’
funding costs were reduced. But, when LIBOR went up, these corporations’ funding
costs increased.
The options allowed the corporations to place an upper limit on their funding costs. That
is, they place a “ceiling” or “cap” their interest cost. As a result, these options became
known as interest rate caps.
The opposite of a ceiling (cap) is a floor, so the multi-period puts became known as
interest rate floors.
The life of a multi-period option is called its tenor.
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Introduction to Structured Notes
payoff
Call
today
0.5
expiration
Time (years)
payoff
today
payoff
payoff
0.5
1.0
1.5
settlement
settlement
settlement
Cap
Payoff = max[L - 7%, 0]  NP  Actual/360
S
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X
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LIBOR is quoted on
an annual basis
23
Introduction to Structured Notes
payoff
today
payoff
payoff
0.5
1.0
1.5
settlement
settlement
settlement
Cap
The cap may be viewed as a portfolio of calls. The first call in the portfolio has six months
to expiry, the second call in the portfolio has one year to expiry, and so forth. These
individual calls, however, are called caplets instead of calls.
To value a cap, we simply value each of the individual caplets (calls) and then sum up the
premiums. The underlying asset is the future value of LIBOR, so we have to employ the
volatility of LIBOR.
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Introduction to Structured Notes
Digital options:
Digital options are options that can take on only one of two values. These are the
values 1 and 0. They are also called binary options.
Digital call or cap:
max[ST – X, 0]
Payoff = ——————
ST – X
Digital put or floor:
max[X – ST, 0]
Payoff = ——————
X – ST
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Introduction to Structured Notes
All-or-nothing options (AoN):
All-or-nothing options are a form of digital option. They are created by
multiplying the value of a digital option by the spot price at expiry of some
asset. Usually this is the underlying asset’s spot price, but it can be the price of
some other asset or the spot price of the asset plus some sum.
All-or-nothing call or cap:
max[ST – X, 0]
Payoff = ———————  (ST + Z)
ST – X
All-or-nothing put or floor:
max[X – ST, 0]
Payoff = ———————  (ST + Z)
X – ST
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Introduction to Structured Notes
Collars:
A involves a long position in the underlying coupled with a short call option and a
long put option on that underlying. The strike of the call XC will be higher than the
strike of the put XP.
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Introduction to Structured Notes
Profit at
Expiry
Profit at
Expiry
Long Call
Short Call
Underlying
Profit = max[ST - X, 0] - Ct
Underlying
Profit = Ct - max[ST - X, 0]
where Ct denotes the premium paid/received at time t for a call option.
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Introduction to Structured Notes
Profit at
Expiry
Profit at
Expiry
Long Put
Short Put
Underlying
Profit = max[X - ST, 0] - Pt
Underlying
Profit = Pt - max[X - ST, 0]
where Pt denotes the premium paid/received at time t for a put option.
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Introduction to Structured Notes
Profit at
Expiry
Long Underlying
Short Call
S
Long Put
S
XC
S
XP
What happens when these three positions are combined?
Note that XC > XP in this example.
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Introduction to Structured Notes
Profit at
Expiry
XP
Underlying (S)
XC
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Introduction to Structured Notes
Forward Contracts:
Originally, forward contracts were privately negotiated contracts for the
delivery at a later date of some specific quantity of some specific asset.
They were similar to futures contracts, but were not standardized and traded
OTC.
Over the past fifteen years, a new type of forward contract has evolved. These
are cash settled based on the value of the underlying at a later date. Such
forward contracts exist on interest rates (called forward rate agreements), on
exchange rates (called forward exchange agreements), on commodities and
on stocks.
Unlike options, no up-front premium is paid or received to enter into a forward
contract.
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Introduction to Structured Notes
When written on stocks, forwards can be written on single stocks, on baskets of
stocks, or on stock indexes. They are usually cash settled and the payment
may be based on either capital appreciation alone or on the total return
(including both capital appreciation and any dividend component).
The total return is usually stated as a percentage (not annualized) and paid on
some quantity of notional principal:
Payoff = D × (TR - CR) × NP
Where:
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D is a dummy variable (+1 if long, -1 if short)
TR is the total return over the relevant period
CR is the contract rate set at the outset (analogous to a strike price)
NP is the notional principal
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Introduction to Structured Notes
Example:
Suppose that you bought a six-month forward contract on the total return on
the S&P. The contract covers $50 million of notional principal. The
contract rate is 6.20%
Payoff = D × (TRSP - CR) × NP
= +1 × (TRSP - 6.20%) × $50 million
How does this payoff function differ from that of an option?
Note: total return is generally stated on a “periodic basis” not on an annual basis the way
interest rates are routinely stated.
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Introduction to Structured Notes
Interest Rate Swap:
Fixed Rate of Interest
(swap coupon)
Counterparty A
Goldman Sachs
Floating Rate of Interest
(reference rate, usually LIBOR)
Notional Principal = $100 mm
Terminology:
notional principal
reference rate
swap coupon
netting
tenor
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Introduction to Structured Notes
Offer
Bid
6.72%
6.68%
Counterparty A
Goldman Sachs
DPG
LIBOR
Counterparty B
LIBOR
Notional Principal = $50 mm
payments made semiannually
tenor = 3 years
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Introduction to Structured Notes
Equity Swaps:
total return on equity benchmark
Counterparty A
Counterparty B
leg X
NP: Usually the same currency
Payments: Usually quarterly
Total return: Dividends plus capital appreciation (positive or negative)
leg X can be:
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floating rate of interest (such as LIBOR)
fixed rate of interest
total return on an another equity index
total return on a single security
total return on some other asset class or index
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Early Structured Securities
Callable Bonds
Putable Bonds
Convertible Bonds
Commodity-Linked Bonds (civil war)
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Building Structured Notes: Floating Interest Rate Structures
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Introduction to Structured Notes
We will assume in each example that the issuer wants to pay a fixed rate. But, in
each case, the investor has a different need. Then, using the basic building blocks
we will “engineer” the desired security.
Note: In all the examples we will look at, we will ignore the difference between
yields quoted on a bond basis and yields quoted on a money market basis.1 We will
also assume, unless stated otherwise, that payments will be made semiannually, so
references to LIBOR imply 6-M LIBOR.
1
Yields and coupons on bonds and coupons on swaps are quoted on a bond basis
and LIBOR is quoted on a money market basis).
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Introduction to Structured Notes
Case I: A Straight Floater
Assume that a corporation could issue a four year-fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a floating
rate pegged to LIBOR.
After some discussions with Goldman Sachs, it is understood that the investor will
take the floater if the floater pays LIBOR + 130 bps.
Let’s build it.
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
Fixed Rate
Structured
Note
4 year
Goal: Satisfy the needs of the issuer and the needs
of the investor. Keep in mind that the structure must
produce a fixed cost no greater than 8.00% for
the issuer.
Achieving the second part of the goal (i.e., reduced cost)
depends on GS’s current pricing of the relevant
derivative products.
What derivative do we need to make this work?
Coupon = LIBOR + 130 bps
Investors
want to hold straight
floater
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
Fixed Rate
Goldman Sachs
Structured
Note
DPG
4 year
Coupon = LIBOR + 130 bps
interest rate swap pricing
bid
offer
4 year
6.50%
6.55%
Investors
want to hold straight
floater
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both quotes are against 6-M LIBOR flat
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 15 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.85%
6.55%
Goldman Sachs
Structured
Note
4 year
DPG
LIBOR
Coupon = LIBOR + 130 bps
Investors
want to hold straight
floater
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Introduction to Structured Notes
Case II: A Capped Floater
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a floating
rate pegged to LIBOR and is willing to accept a cap of 9% (i.e., under no
circumstances with the coupon exceed 9%).
After some discussions with Goldman Sachs, it is understood that the investor will
take the floater if the floater pays LIBOR + 150 bps.
Let’s build it.
Note, that this investor wants 20 bps more than the prior investor. Why?
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
Goldman Sachs
Fixed Rate
interest rate swap pricing
4-year plain vanilla
Structured
Note
bid
6.50%
offer
6.55%
LIBOR option pricing
Coupon = min[LIBOR + 150 bps, 9%]
bid
offer
4-year 7.50% LIBOR cap
30 bps
40 bps
(premium here is stated on an annual basis)
Investors
want to hold capped
floater
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
Note that by this structure the
corporate has saved 25 bps relative
to issuing a straight fixed-rate note.
7.75%
6.55%
interest rate swap
LIBOR
Structured
Note
Goldman Sachs
DPG
max[LIBOR - 7.50%, 0]
4 year
corporate sells 4-year 7.50% LIBOR cap to dealer
Coupon = min[LIBOR + 150 bps, 9%]
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30 bps
Investors
dealer agrees to pay corporate a premium equivalent to 30 bps a year
want to hold capped
floater
Note: option premia are usually paid in full up-front, but this can be annuitized.
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Introduction to Structured Notes
Case III: A Collared Floater
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a floating
rate pegged to LIBOR and is willing to accept a cap of 9% provided that the note
will also have a floor of 6% (i.e., under no circumstances will the coupon exceed
9% or be less than 6%).
After some discussions with Goldman Sachs, it is understood that the investor will
take the floater if the floater pays LIBOR + 100 bps.
Let’s build it.
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
Goldman Sachs
Fixed Rate
interest rate swap pricing
4-year plain vanilla
Structured
Note
bid
6.50%
offer
6.55%
LIBOR option pricing
bid
4-year 8.00% LIBOR cap 20 bps
4-year 5.00% LIBOR floor 35 bps
offer
30 bps
45 bps
Coupon = max[min[LIBOR + 100 bps, 9%], 6%]
(premiums here are stated on an annual basis)
Investors
want to hold
collared floater
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
7.80%
Note that by this structure the
corporate has saved 20 bps relative
to issuing a straight fixed-rate note.
6.55%
interest rate swap
LIBOR
max[LIBOR - 8.00%, 0]
Structured
Note
corporate sells 4-year 8.00% LIBOR cap to dealer
(dealer agrees to pay corporate 20 bps a year)
max[5.00% - LIBOR, 0]
4 year
Goldman Sachs
DPG
corporate buys 4-year 5.00% LIBOR floor from dealer
(corporate agrees to pay dealer 45 bps a year)
Coupon = max[min[LIBOR + 100 bps, 9%], 6%]
20 bps
Investors
want to hold
collared floater
10/02/01
45 bps
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Introduction to Structured Notes
straight floater
Investor’s
coupon
capped floater
collared floater
LIBOR
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Introduction to Structured Notes
The issuance of structured securities, often through private placements, allows
the issuer to tap into different demand segments (i.e., straight floaters, capped
floaters, collared floaters, etc.). By tailoring different portions of the issuance
to specific investor demands, Goldman Sachs is often able to help the issuer to
reduce its financing costs relative to a straight issuance of its desired type of
liability.
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Introduction to Structured Notes
Before moving on to equity and commodity linked notes, we look at two more
types of floating rate structured notes:
Range floaters (also called range notes)
CMT floaters
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Introduction to Structured Notes
Case IV: A Range Floater (also called a range note)
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a floating
rate pegged to LIBOR provided that LIBOR stays within a very well defined range
of 5% to 8%. The investor feels very confident that LIBOR will stay within the
range.
The investor is willing to hold the range floater provided it pays LIBOR + 200 bps
while LIBOR is within the range and the investor is willing to accept nothing if
LIBOR strays outside the range.
This structure requires all-or-nothing options! Let’s build it.
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Introduction to Structured Notes
Goldman Sachs
Corporate
interest rate swap pricing
issuer wants to pay fixed
4-year plain vanilla
Fixed Rate
bid
6.50%
offer
6.55%
LIBOR all-or-nothing option pricing
bid
4-year 8.00% LIBOR cap 50 bps
4-year 5.00% LIBOR floor 40 bps
Structured
Note
offer
55 bps
45 bps
(premiums here are stated on an annual basis)
Coupon = LIBOR + 200 bps if 5%  LIBOR  8%
= 0 if LIBOR < 5% or LIBOR > 8%
Investors
max[5.00% - LIBOR, 0]
—————————— × (LIBOR + 200 bps)
5.00% – LIBOR
want to hold range
floater
10/02/01
max[LIBOR - 8.00%, 0]
—————————— × (LIBOR + 200 bps)
LIBOR – 8.00%
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 35 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.65%
6.55%
interest rate swap
LIBOR
max[LIBOR - 8.00%, 0]
—————————— × (LIBOR + 200 bps)
LIBOR - 8.00%
Structured
Note
corporate sells 4-yr 8.00% LIBOR AoN cap to dealer
4 year
Goldman Sachs
DPG
max[5.00% - LIBOR, 0]
—————————— × (LIBOR + 200 bps)
5.00% - LIBOR
corporate sells 4-yr 5.00% LIBOR AoN floor to dealer
Coupon = LIBOR + 200 bps if 5%  LIBOR  8%
= 0 if LIBOR < 5% or LIBOR > 8%
50 bps
Investors
want to hold range
floater
10/02/01
40 bps
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Introduction to Structured Notes
Investor’s
coupon
range floater
collared floater
LIBOR
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Introduction to Structured Notes
Case V: CMT Floater
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a floating
rate pegged to the yield on the 5-year on-the-run Treasury. Specifically, the investor
is willing to hold the debt if it pays the 5-yr CMT plus 80 bps.
This structure requires a CMT swap! Let’s build it.
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Introduction to Structured Notes
Corporate
Goldman Sachs
issuer wants to pay fixed
5-yr CMT swaps
tenor
Bid
Offer
1-yr
6.48% 6.56%
2-yr
6.65% 6.73%
3-yr
6.74% 6.82%
4-yr
6.80% 6.88%
5-yr
6.86% 6.94%
6-yr
6.88% 6.97%
fixed
Structured
Note
4 year
Coupon = 5-yr CMT + 80 bps
in all cases the fixed rates
above would be paid against
the yield on the 5-year on-therun Treasury
Investors
want to hold CMT
floater
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Introduction to Structured Notes
6.88%
Corporate
Goldman Sachs
5-yr CMT yield
yield
yield curve 6-month after inception
7.12%
6.32%
yield curve at time of inception
5 years
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maturity
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 32 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.68%
6.88%
Structured
Note
4 year
Goldman Sachs
CMT interest rate swap
DPG
yield on 5-yr CMT
Coupon = 5-yr CMT + 80 bps
Investors
want to hold CMT
floater
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Fixed Rate Structures
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Introduction to Structured Notes
There are many types of fixed rate structured notes. Some employ a fixed
coupon that periodically “steps up” or “steps down” to preset higher or lower
levels. These are created using step up and step down interest rate swaps.
Others pay a fixed rate in a currency other than that in which the note is
denominated. We will look at this latter structure.
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Introduction to Structured Notes
Case VI: Dual Currency Fixed Rate Structure
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00%.
An investor is willing to hold this corporation’s debt, but wants to receive a fixed
rate in euros rather than in dollars, because the investor feels that the euro will
strengthen against the dollar over the next few years. But, the investor wants the
bond to be redeemed at maturity for dollars (that is, the par value will be returned at
maturity in dollars).
The investor requires a fixed rate of 8.10% on the euro par value equivalent (at the
time the swap is written).
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Introduction to Structured Notes
Corporate
Goldman Sachs
issuer wants to pay fixed
fixed rated in dollars on USD principal
USD interest rate swaps
tenor
Bid
Offer
4-yr
6.80% 6.84%
quotes are against USD LIBOR flat
Structured
Note
4 year
EUR interest rate swaps
tenor
Bid
Offer
4-yr
7.20% 7.24%
quotes are against EUR LIBOR flat
Coupon = fixed (8.10%) in euros on euro principal
Investors
want to hold dual
currency note
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Introduction to Structured Notes
Assume spot exchange rate is 1 euro = $0.90
6.84% on USD
Corporate
Goldman Sachs
USD IR Swap
Goldman Sachs
IR Parity
Goldman Sachs
EUR IR Swap
USD LIBOR
USD LIBOR
Corporate
EUR LIBOR
EUR LIBOR
Corporate
7.20% on EUR
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Introduction to Structured Notes
6.84% on USD + 86 bps
Corporate
Goldman Sachs
USD IR Swap
Goldman Sachs
IR Parity
Goldman Sachs
EUR IR Swap
USD LIBOR + 86 bps
USD LIBOR + 86 bps
Corporate
EUR LIBOR + 90 bps
EUR LIBOR + 90 bps
Corporate
7.20% on EUR +90 bps
Begin here
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Introduction to Structured Notes
6.84% on USD + 86 bps
Corporate
×
×
×
×
Goldman Sachs
USD IR Swap
Goldman Sachs
IR Parity
Goldman Sachs
EUR IR Swap
USD LIBOR + 86 bps
USD LIBOR + 86 bps
Corporate
EUR LIBOR + 90 bps
EUR LIBOR + 90 bps
Corporate
7.20% on EUR +90 bps
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Introduction to Structured Notes
7.70% on dollar NP
Corporate
×
×
×
×
Goldman Sachs
USD IR Swap
Goldman Sachs
IR Parity
Goldman Sachs
EUR IR Swap
USD LIBOR + 86 bps
USD LIBOR + 86 bps
Corporate
EUR LIBOR + 90 bps
EUR LIBOR + 90 bps
Corporate
8.10% on euro NP
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 30 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.70% in $100
7.70% on USD NP
Goldman Sachs
Structured
Note
fixed-for-fixed currency swap
4 year
8.10% on EUR NP
DPG
Coupon = 8.10% on 111.11 euros
Investors
Par = $100, payable at maturity
want to hold dual
currency note
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Equity Linked Notes
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Introduction to Structured Notes
Equity Linked Notes:
Equity linked notes are debt instruments that pay a coupon that is linked to the
return on some equity index or some equity basket. Alternatively, the coupon could
be fixed, but the principal at maturity might be linked to some equity index or
basket.
We will consider the construction of both types.
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Introduction to Structured Notes
Case VII: An Equity-Linked Coupon Structure (principal protected).
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00% in two semiannual installments.
An investor is willing to hold this corporation’s debt, but wants to receive a coupon
tied to the performance of some equity index. At the same time, the investor wants
the principal on the note protected so that he is assured of full repayment at maturity.
Finally, it is important that the coupon never be negative!
Suppose that the investor would be willing to take a coupon tied to the total return
on the S&P 500 (TRSP) and that payments will be made quarterly. Specifically, the
note would pay max[TRSP - 100 bps, 0] quarterly.
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 15 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.85%
6.55% (annual rate pd sa)
interest rate swap
LIBOR (3-M LIBOR pd qr)
Structured
Note
4 year
LIBOR + 30 bps (3-M LIBOR pd qr)
equity swap
Goldman Sachs
DPG
TRSP (quarterly TR)
100 bps - TRSP if TRSP < 1% (also qu)
equity floor
Coupon = max[TRSP - 100 bps, 0] paid quarterly
Investors
for the floor, the corporate pays GS
a premium that annualizes to 800 bps
at the rate of 200 bps a quarter.
want to equity-linked
note
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Introduction to Structured Notes
Corporate
issuer wants to pay fixed
7.85%
6.85% annual rate paid semiannually
Structured
Note
4 year
Goldman Sachs
interest rate swap
DPG
TRSP if TRSP > 1%, else 100 bps - TRSP
(this TRSP is paid quarterly)
Coupon = max[TRSP - 100 bps, 0] this coupon is paid quarterly
Investors
for the floor, the corporate pays GS
a premium that annualizes to 800 bps
at the rate of 200 bps a quarter.
want to equity-linked
note
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Introduction to Structured Notes
Case VIII: An Equity-Linked Principal Structure (principal protected).
Assume that a corporation could issue a four-year fixed rate note if it agreed to pay a
fixed rate of 8.00% in two semiannual installments.
An investor is willing to hold this corporation’s debt. The investor wants to receive
a fixed coupon and would accept 3.00%, provided that the investor would also
receive that portion of the 4-year total return on the S&P 500 in excess of 48%,
provided that that is a positive sum.
Suppose that Goldman Sachs would sell a four-year call option whose payout is as
follows:
Payout at end of four years = max[TRSP - 48%, 0]
GS would charge 450 bps a year in semiannual installments of 225 bps each.
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Introduction to Structured Notes
Note that by this structure the
corporate has saved 50 bps relative
to issuing a straight fixed-rate note.
Corporate
issuer wants to pay fixed
7.50%
4.50% sa
Goldman Sachs
Structured
Note
4 year
DPG
max[TRSP - 48%, 0]
(payable at the end of 4 years)
Coupon = 3%
Investors
want to equity-linked
note
10/02/01
Par at maturity = 100 + max[TRSP - 48%, 0] × 100
measured over 4 years
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Case Studies
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Introduction to Structured Notes
Case Study I: Goldman Sachs-Skopbank
•
•
•
•
•
•
•
•
10/02/01
December 1989
Japanese life insurance companies seeking enhanced interest income
Skopbank AAA rated
Skopbank traditional funding in US dollars and at $LIBOR flat
Nikkei 225 at about 38,200
Seasoned 1-year AAA-rated Euro-Yen bonds yielding 6.10%
Yen-dollar rate at about Y144/US$1
Annualized vol of Nikkei about 13% (in Yen)
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Introduction to Structured Notes
•
Terms of Issuance:
Issuer:
Size:
Coupon:
Maturity:
Issue Price:
Call Options:
Denomination:
Commissions:
Redemption:
Skopbank
Y6.7 billion
7%
1 Year
101-1/8
None
Y100 million
1-1/8
If at maturity, Nikkei > 31,870.04, then
redemption at par. If Nikkei < 23,902.53, then
redemption is zero. If in between, then
redemption is
Y100 million x {1 - [(4)(31,870.04 - Nikkei)/(31,870.04)]}
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Introduction to Structured Notes
•
Skopbank issues a plain-vanilla 1-year, fixed-rate Euro-Yen bond and buys an
embedded, European-style, out-of-the-money capped put on the Nikkei 225.
•
A capped put is a combination of two puts, short one put with a higher exercise
price and long an otherwise identical put with a lower exercise price. Here the
two strike prices are 31,870.04 and 23,902.53. The capped put precludes the
investor (Japanese life insurance companies) from having to pay the issuer
(negative redemption) should the Nikkei fall below 23,902.53 at expiration.
The capped put is out-of-the-money because the two strikes are well below the
current level of the Nikkei at issuance (38,200).
•
The instrument is coupon guaranteed by not principal guaranteed. The
principal component has four times leverage.
•
The investor picks up 90 basis points in enhanced coupon for writing the
capped put.
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Introduction to Structured Notes
•
Graphically, the redemption formula looks like the following:
% Redemption
100%
Slope = 4
0%
23,902.53
10/02/01
31,870.04
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Nikkei 225 at Maturity
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Introduction to Structured Notes
•
Skopbank will seek to “reverse engineer” the issue and, economically
speaking, get back to floating dollar funding at sub-LIBOR. Skopbank will
need to achieve a sub-LIBOR funding rate because (a) otherwise it would just
issue floating dollar funding in the first place, and (b) it will assume some
counter party credit risk with Goldman.
•
Specifically, Skopbank will look to sell off its embedded capped put to
Goldman (enter Goldman’s equity derivatives desk) and to convert the Yendenominated fixed coupon obligation to a floating dollar obligation (enter
Goldman’s cross-currency interest rate swap desk). Skopbank will convert the
Yen proceeds from the issue into dollars, and reconvert dollars back to Yen via
the real principals on the swap.
•
Note that I do not have the exact terms of the swap done in this deal, so the
figures appearing on the next page are just representative.
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Introduction to Structured Notes
•
We have:
Skopbank
Capped Put on Nikkei
1-1/8% Commission (or
about $525,000)
Yen 6.7 billion (today)
100% + $LIBOR - 20 bps (in
one year on $46.5278 million)
Goldman
Sachs
$46.5278 million (today)
107% (in one year on
Yen 6.7 billion)
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Introduction to Structured Notes
•
In this case, at the end of the day, Skopbank has issued about $46.5278
million at an all-in cost of 20 basis points below $LIBOR.
•
How much money Goldman makes all-in depends critically on what it will
fetch for the capped put. (In addition, Goldman will have to hedge the
risks occasioned by the cross-currency interest rate swap transaction.) In
this case, Goldman refashioned the Nikkei puts and resold them to retail
investors as Nikkei Put Warrants listed on the Amex. (One might say that
Goldman could profit if the implied vol of the embedded put was lower
than that of the listed put it in turn sold.)
•
On a forensic note, the Nikkei closed at around 23,000 at the maturity of
the Skopbank issue.
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Introduction to Structured Notes
Case Study II: Goldman-Disney
•
•
•
•
10/02/01
In 1985, Disney acquired Arvida (real estate inventories) and paid greenmail to
Saul Steinberg
As a result, Disney had a substantially more levered balance sheet and had a
significant debt maturity profile problem. It had $862 million in debt ($215
million to acquire Arvida and $328 million to repurchase 4.2 million shares
from Steinberg). TD/TA rose from to 43% from about 20% just one year
earlier. Two-thirds of the total debt consisted of short-term bank loans and CP.
Disney was rated a weak single A.
Since 1983, Disney had a licensing agreement with a Japanese company
related to Disney Tokyo. Gate receipts were rising and so were Disney’s Yendenominated royalties, but the dollar had been depreciating, occasioning losses
on the exchange component.
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Introduction to Structured Notes
•
Thus Disney’s treasury officers sought to solve both problems by, in part,
issuing long-term debt in Yen, converting the proceeds to dollars and paying
down some of the short-term bank loans and CP, and using the Yendenominated gate receipts to service the debt.
•
Being a weak single A, a Euro-yen issue by Disney could not float in the
Eurobond marketplace.
•
Disney could obtain a 10-year Yen term loan from a consortium of Japanese
banks. The loan would be fixed rate with a s.a. coupon of 3.75% and up front
fees of 75 basis points. The principal would be Yen 15 billion or, at an
exchange rate at the time of about Y250/US$1, about $60 million. Thus the
all-in cost of the loan, in Yen, would be 7.75% p.a. (r = IRR = 3.804% s.a. or
7.75% p.a.):
100.00 - 0.75 = 3.75/(1 + r) + 3.75/(1 + r)^2 + … + 103.75/(1 + r)^20.
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Introduction to Structured Notes
•
Goldman suggested an alternative strategy to Disney whereby it would issue a 10year Euro-ECU bond and then swap to Yen. The ECU proceeds would be
exchanged in the spot market for dollars and used to pay down some of Disney’s
short-term debt, thus restructuring its debt maturity profile. The Disney Tokyo
Yen-denominated royalties would be used to service the swap payments. (The
ECU was a trade-weighted basket of Common Market currencies and the
forerunner of today’s euro. At the time, the ECU was the second leading European
currency behind the then West German mark.)
•
Goldman had identified a AAA-rated French utility with an already outstanding
Euro-Yen bond that had about 10 years to maturity and was yielding about 6.83%
p.a. It also had a 10-year outstanding Euro-ECU bond that was yielding about
9.37%.
•
So the question was, Could Disney issue Euro-ECU and swap to Yen at an all-in
funding cost that was lower than the 7.75% p.a. rate on the Japanese term loan?
And could Goldman and the French utility profit too?
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Introduction to Structured Notes
•
The terms of the Euro-ECU bond were:
Par:
ECU 80 million (also about $60 million at the time)
Price:100.250%
Coupon:
9.125% p.a.
Fees:
2%
Expenses:
$75,000
Sinking Fund: 5-year straight line beginning in Year 6
Dollar/ECU: $0.7420
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Introduction to Structured Notes
•
Given these terms, the cash flows on the Euro-ECU issue occasioned an all-in
funding cost to Disney of just 9.47% (the IRR from the cash flow stream
below):
Year
0
1
2
3
4
5
10/02/01
Cash Flow (million ECU)
78.499
(7.300)
(7.300)
(7.300)
(7.300)
(7.300)
Year Cash Flow (million ECU)
6
(23.300)
7
(21.840)
8
(20.380)
9
(18.920)
10
(17.460)
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Introduction to Structured Notes
•
At this point we can readily see an arbitrage opportunity. Call it “relative
credit spread arbitrage”. As the table below indicates, whereas the French
utility being rated AAA has an absolute advantage in issuing in both ECU and
Yen, Disney has a comparative advantage in issuing in ECU. Disney’s relative
credit spread in ECU is just 10 basis points, whereas it is 92 basis points in
Yen. Buyers of the Euro-ECU issue appear to be overpricing the issue. The
difference between the two relative credit spreads is 82 basis points and
represents the “pie” that can be sliced up among Disney, the French utility, and
a swap dealer (presumably Goldman at first thought).
Fr. Utility (AAA)
Disney (A-)
Spread
10/02/01
ECU
9.37% p.a.
9.47% p.a.
10 bps
Yen
6.83% p.a.
7.75% p.a.
92 bps
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Introduction to Structured Notes
•
So Disney should issue in ECU and swap to Yen, the result of which is for
Disney to service the French utilities outstanding Euro-Yen debt and the
French utility to service Disney’s Euro-ECU debt:
Yen Payments (A)
Disney
ECU Payments (B)
Yen Payments(C)
Swap
Dealer
ECU Payments (D)
ECU78.5 million (from Euro-ECU issue)
$60 million (to service short-term debt)
Yen (from Disney Tokyo royalties)
ECU Payments (to service Euro-ECU bond)
ECU (from operating cash flows)
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French
Utility
Yen (to
service
Euro-Yen
bond)
92
Introduction to Structured Notes
•
The next slide shows the actual cash flows on the swap. The swap dealer in
this case turned out to be the Industrial Bank of Japan (IBJ), which was then
AAA rated. (It could have been that the French utility demanded a bettercredited counter party than Goldman on the 10-year swap.)
•
The columns are labeled A, B, C and D and comport to the arrows labeled
similarly in the previous slide.
•
When one computes the IRRs using the cash flows in the columns, one sees
that Disney’s all-in funding cost in Yen (from issuing the Euro-ECU bond and
swapping to Yen) was just 7.01%. That is a savings of 74 bps versus using the
Yen term loan (7.75%). IBJ took 6 bps and therefore the French utility saved 2
bps (giving a total of 82 bps).
•
Conclusion: Disney funds in Yen at just 18 bps above a AAA despite being a
weak single A.
•
Discuss IBJ’s “hari kari” swap.
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Introduction to Structured Notes
•
•
Note that the swap cash flows ignore any fees baid to either IBJ or Goldman. The dollar/ECU
was $0.7420 and the Yen/dollar was Y248. The initial Yen principal received by Disney from
IBJ is relevant only to the swap transaction and the calculation of an all-in Yen financing cost.
By exchanging the initial Yen for dollars in the spot market, Disney would obtain new dollar
funding. The principal amounts for the French utility are strictly notional as no net new
funding is obtained by the utility as a result of the swap.
ECU/Yen Swap Flows (Million)
Disney Swap Flows:
Fr. Utility Swap Flows:
(Paid to)/received from IBJ
Received from/(paid to) IBJ
Year
Yen (A)
ECU (B) Yen (C)
ECU (D)
0
14,445.153
(78.499) (14,445.153)
80.000
0.5
(483.226)
483.226
1
(483.226)
7.300
483.226
(7.350)
1.5
(483.266)
483.266
2
(483.266)
7.300
483.266
(7.350)
2.5
(483.266)
483.266
3
(483.266)
7.300
483.266
(7.350)
(table continued on next slide)
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Year
3.5
4
4.5
5
5.5
6
6.5
7
7.5
8
8.5
9
9.5
10
10/02/01
Disney Swap Flows:
Paid to/(received from) IBJ
Yen (A)
ECU (B)
(483.266)
(483.266)
7.300
(483.266)
(1,808.141)
7.300
(1,764.650)
(1,721.160)
23.300
(1,677.670)
(1,634.179)
21.840
(1,590.689)
(1,547.199)
20.380
(1,503.708)
(1,460.218)
18.920
(1,416.728)
(1,520.450)
17.460
Fr. Utility Swap Flows:
Received from/(paid to) IBJ
Yen (C)
ECU (D)
483.266
483.266
(7.350)
483.266
1,808.141
(7.350)
1,764.650
1,721.160
(23.350)
1,677.670
1,634.179
(21.880)
1,590.689
1,547.199
(20.410)
1,503.708
1,460.218
(18.940)
1,416.728
1,520.450
(17.470)
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Introduction to Structured Notes
More Modern Applications:
During the second half of the 1980s and first half of the 1990s, interest rate
derivative desks discovered that the call option embedded in a callable bond
could be replicated by a swaption. As a result, underwriters, working with
their interest rate derivative desks, schooled corporate treasury officers on how
to issue a callable bond and then sell-off (economically speaking) the
embedded call by writing a swaption. If the embedded call could be
purchased cheaply by the corporate issuer, that is, the added coupon was small
compared to a straight-bond alternative, then the corporation’s overall funding
cost would be lower (than the straight-debt alternative) after selling off the call
by writing the swaption. At the end of the day, the embedded call was cheaper
if its implied vol was lower than that of the swaption. We have:
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Issue callable bond
+ Write a swaption
Issue straight debt
(issue straight debt and buy back a call)
(sell off embedded call)
(lower coupon than issuing straight debt
directly if the implied vol of the swaption is
greater than that of the embedded call)
Of course, the investment bank could help discover (or create) value for the
buy-side under this same process. If the implied vol of the embedded call is
greater than that of the swaption, then the investor - say a hedge fund that buys
the debt issue under a 144A offering - could buy the bond (possibly financing
the purchase in the repo market) and buy the swaption. To isolate the value
more precisely, the buyer could hedge the credit risk of the bond with a credit
derivative.
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•
10/02/01
Indeed, some now argue that the flood of embedded stock options
accompanying these convertible issues has created a “volatility crush” or
“volatility overhang” in the equity market. It is a fact that the market has been
“taking out” time value from options, perhaps because of an excessive supply
of vol. Volatility traders who have been delta and gamma neutral but carrying
negative vegas have generally profited in 2001 (whereas such a strategy was
generally a loser for the preceding five years).
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