The perfect Hedger and the Fox
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Transcript of The perfect Hedger and the Fox
THE PRACTICAL APPLICATION OF EQUITY DERIVATIVES FOR
CORPORATES
The perfect Hedger and the Fox17 April 2013
Dr Antonie Kotzé
Financial Chaos Theory
Before I came here I was confused about the subject.
Having listened to your lecture I am still confused.
But on a higher level.Enrico Fermi (1901-1954)
Niels Bohr
and
Albert Einstein
What’s in the 1997 Nobel prize?
Myron Scholes (1941 - )
Robert Merton (1944 - )
Fischer Black (1938 - 1995)
Along the way, it changed the way investors
and others place a value on risk, giving rise to
the field of risk management, the increased
marketing of derivatives, and widespread
changes in the valuation of corporate
liabilities.
The theory "is absolutely
crucial to the valuation of
anything from a company
to property rights“. In my
view, financial
economics deals with
four main phenomena:
time, uncertainty, options and
information.William F. Sharp
What’s in it for corporates?
Derivatives expanded the
universe of
instruments available
for trading and
hedging
Corporates and equity warrants
Can corporates utilise
equity derivatives
effectively?
YES
Corporates as hedgers use derivatives
to reduce the market and operational
risks they are exposed to
Saggitarius A
Black-Scholes through the eyes of.....
Let’s demistify options
Derivatives as simple diagrams
a future has unlimited profit potential, but such a
diagram also shows the potential losses
P/LShort
Future
K K’
Long
Future
Options as simple diagrams
K
Long
Put
Payoff
KShort
Put
Payoff
KShort
Call
Payoff
K
Long
Call
Payoff
A payoff profile shows the payoff
that would be received if the
underlying is at its current
level when the option expires
The Formulas
• Future
• Option
Useful Diagrams
A payoff profile shows the payoff that would be received if the
underlying is at its current level when the option expires
It highlights the risks associated with the strategy in a simple
diagram: a future has unlimited profit potential, but such a
diagram also shows the potential losses
It is easy to work with payoff profiles - they are additive meaning
that we can add or subtract them from one another ---
useful in constructing more complex financial instruments or
strategies
The put and/or call strategy
Bullish Strategy
Buying just a call can be a strategy
The investor will profit from an
upward move in the underlying stock
price while having very little capital
at risk
Bearish Strategy
Buying a put is also a strategy
In general investors buy a put as a
hedge when they are long the
underlying stock
Albert Einstein
Share buybacks
Board decides to buy shares back if
share price goes below a certain level
Company writes OTM puts
Example: share price at 100, board
decides to buy shares if share price
dips below 90
Company receives premium incomeMyron Scholes on the floor
of the CBOE
SENS Announcement
On 29 August 2002 Venfin (VNF) sent out a SENS
Cautionary announcement
Shareholders are advised that VenFin has entered into
discussions with Hosken Consolidated Investments Limited
regarding the proposed purchase of the latter's interest in
Vodacom Group (Proprietary) Limited. Accordingly,
shareholders are advised to exercise caution when dealing in
their VenFin shares.
Financial Engineering
On 9 September 2002 VNF sent out a further SENS
VenFin has acquired a put option from Merrill Lynch
International (MLI) in respect of 51 858 000 Richemont
depositary receipts held by VenFin;
and MLI has acquired a call option from VenFin in respect of
51 858 000 Richemont depositary receipts held by VenFin.
The Vodacom Connection
On 16 January 2003 VNF sent out a further SENS
Announcement regarding exercise of the put option acquired
from Merrill Lynch International ("MLI")
The total cash proceeds realised by VenFin as a result of
exercising the put option are R945.2 million. The proceeds
from the exercise of the put option were used in part to settle
the purchase price of the 1.5% interest in Vodacom Group
(Proprietary) Limited ("Vodacom") acquired from Hosken
Consolidated Investments Limited.
An Innovative Funding Strategy
Speaking on Classic Business David Shapiro said the financing
arrangement was called a collar and involved Venfin putting up the
shares as security for a loan from Merrill Lynch.
Shapiro described the arrangement as a “new, innovative way in
which to loan money and to protect collateral”.
What happened here?
History
In 1993 the then Rembrandt Group invested R100 million into
Vodacom for 15% of the shareholding. Vodafone got 35% and
Telkom 50%
In 1995 Rembrandt sold 5% (1.5% from itself and 3.5% from
Vodafone) to HCI for R90 million – a BEE deal
It now bought that 5% stake back for R1.5 billion (again keeping
1.5% for itself and Vodaphone takes 3.5%)
RETURN!!
More History
Venfin inherited 2% of
Richemont’s share capital
when the Rembrandt Group
split into Remgro and Venfin
during 2000
Venfin used these shares in an innovative manner to fund the
purchase of HCI’s Vodacom’s stake
How?
S
Long
Richemont
Long
put
K= 18.22
Short
call
Venfin’s Ambitions
HCI has drawn loan funding from Venfin of some R600 million to
recapitalise e-tv
This loan was converted into equity and Venfin now indirectly
(through Sabido Investments) owns 33.1% of e-tv
Venfin enlarged their stake in Vodacom by, efficiently, using a non-
strategic investment
Why?
Simple solution could have been: sell shares at beginning of the negotiations, put money on deposit and buy stake on finalisation
Why through such a structure as described above?
Norbert Wiener
– Uncertainty regarding the outcome of negotiations – if negotiations failed they did not have to exercise option
– Richemont declared a dividend with LDT date in this period – 27 Sep 2002
– Venfin kept all its share holder rights until the deal was finalised on 31 Dec 2002
A Great Deal
Venfin received the dividend amounting to R17,076,839.40 (tax
benefit)
The strike of the put was at R18.22
On 31 December 2002 RCH price was R15.90
Venfin financed deal at R18.22
Corporate Warrants
Different to warrants currently traded on the JSE
Warrants traded on JSE issued by independent financial
institutions – no effect on issued share capital
Corporate/company warrants are issued by the company
itself on its own stock
If corporate warrants are exercised company receives cash
(company’s value increases) as well as the number of
shares on issue increases
Uses for Corporate Warrants
Cheap way to raise capital – receive premium now and
capital later
More certainty in capital raising program
Do not have to pay any dividends until warrants are
exercised
A History on Tabacco
In 1995 Rembrandt and Richemont consolidated their respective
tobacco interests in Rothmans International – the world’s fourth
largest cigarette manufacturer
During June 1999 Rothmans merged with British American
Tobacco Plc (BAT) to form the world’s second largest cigarette
producer
Remgro and Richemont’s investment in BAT is held through R&R
Holdings – Remgro and Richemont hold 33 1/3% and 66 2/3%
respectively
R&R owns 31.5% of BAT
Hedging using corporate warrants
R&R’s stake in BAT was split into 26.5% ordinary shares and 5% preference shares with embedded put options at a strike of 675p
The preference shares amounted to some 120.9 million shares
The put options expire on 7 June 2004
The preference shares automatically converted into ordinary shares on a one to one basis on any sale to a third party
R&R wanted certainty on the optionality
The Manhatten Project: Niels Bohr, Robert
Oppenheimer, Richard Feynman, Enrico Fermi
Source: SENS
R&R’s Call Warrants on BAT
SENS Announcement on 11 December 2002
Compagnie Financiere Richemont SA (RCH) announces that its
subsidiary, R&R Holdings SA is to offer 120.9 million secured
European-style call warrants exercisable only upon maturity, at the
option of the warrant holder, into ordinary shares of British
American Tobacco p.l.c. (‘BAT’). The warrants, which will expire in
May 2004, are exercisable at 675p per warrant.
Remgro had a similar announcement
Long
preference
shares
K=675p
Long
putSynthetic
call
Short
call
Position:
SQUARE
The structure
Lock in returns
In June 2004, R&R Holdings received
GBP 816 million, either upon exercise
of the warrants by the warrant holders
or through the redemption of the
preference shares by BAT
By issuing warrants R&R was guaranteed of GBP
816 million
R&R sold the time value and option rights
embedded in the synthetic call, unlocking value
early
Enrico Fermi
Corporate warrants, the LTCM and UBS way
Report: International Herald
Tribune, Saturday, September
26, 1998
Losses due to the failure of Long Term
Capital Management (LTCM):
Credit Suisse, Europe's sixth-biggest
bank - $55 million
Dresdner Bank - $142.6 million
Union Bank of Switzerland (UBS – the
world’s second largest bank) - $682
million
What happened?
A convenient deal
LTCM was on the crest of the wave
LTCM and UBS had complementary goals:
UBS wanted to buy a significant stake in the fund, and LTCM partners wanted to convert foreign interest income from their off-shore hedge fund into capital gains and defer it for 7 years
Income from LTCM flows directly to the partners in the form of short-term profits or interest and dividends, which are taxed at 39.6 percent. Long-term capital gains, by contrast, are taxed at 20 percent.
UBS wanted a structure that looked more like an option than a
loan, turning any income into a capital gain, and they wanted an
opportunity to invest directly into LTCM.
A Tax Deal
The deal solved a tax problem faced by LTCM and other hedge funds: most funds are set up as partnerships or limited liability corporations
Income from the fund flows directly to the partners in the form of short-term profits or interest and dividends, which are taxed at 39.6 percent. Long-term capital gains, by contrast, are taxed at 20 percent.
UBS: the deal
For a premium of $300 million UBS sold to LTCM a seven-year European call option on 1 million of LTCM's own shares, valued then at $800 million.
To hedge the position UBS bought $800 million worth of LTCM shares.
This transaction was completed in three tranches in June, August and October 1997.
UBS also invested $300 million directly in LTCM i.e., the premium. Such an investment had to be held for a minimum of three years.
Any shares sold by UBS had to be converted into a loan at par value
UBS booked an estimated $30 to $50 million profit up front
The deal was a variation on other attempts to turn hedge funds into a securitized asset class with a protected downside. UBS was protecting the downside.
Enrico Fermi
The Premium
The deal was calculated so that the $300 million premium was equivalent to a coupon of Libor
plus 50 basis points over the seven years.
A Clever Deal
LTCM secured $800 million new investment capital at Libor plus 50 basis points. It had a call on all returns above that level.
UBS gets its capital back after 7 years by selling the shares at the strike price
UBS's obligation, to convert any shares it wanted to sell into a loan, provided LTCM with a synthetic seven-year put on its own performance.
S
Long LTCM
shares
Short
call
Short
synthetic
put
A clever deal?
UBS’s risk management
Hedge fund shares are not liquid
When Russia defaulted on loans
in 1998, liquidity dried up
UBS could not delta hedge its
short synthetic put by selling
LTCM shares
LTCM’s share price collapsed and
UBS lost $682 million
UBS’s risk
managers never
considered the
possibility of a
collapse of LTCM
Hedgers and foxes
Equity derivatives can be used
effectively by corporates to
hedge certain contractual
liabilities
Understand the risks involved
Contact and Disclaimer
Dr Antonie Kotzé
Email: [email protected]
Phone: 082 924-7162
Disclaimer
This article is published for general information and is not intended as
advice of any nature. The viewpoints expressed are not necessarily that of
Financial Chaos Theory. As every situation depends on its own facts and
circumstances, only specific advice should be relied upon.