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The perfect Hedger and the Fox


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The perfect Hedger and the Fox

  1. 1. THE PRACTICAL APPLICATION OF EQUITY DERIVATIVES FOR CORPORATES The perfect Hedger and the Fox 17 April 2013 Dr Antonie Kotzé Financial Chaos Theory
  2. 2. 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
  3. 3. 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
  4. 4. What’s in it for corporates? Derivatives expanded the universe of instruments available for trading and hedging
  5. 5. 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
  6. 6. Black-Scholes through the eyes of..... Let’s demistify options
  7. 7. Derivatives as simple diagrams  a future has unlimited profit potential, but such a diagram also shows the potential losses P/L Short Future K K’ Long Future
  8. 8. Options as simple diagrams K Long Put Payoff K Short Put Payoff K Short 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
  9. 9. The Formulas • Future • Option
  10. 10. 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
  11. 11. 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
  12. 12. 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 income Myron Scholes on the floor of the CBOE
  13. 13. 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.
  14. 14. 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.
  15. 15. 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. 
  16. 16. 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?
  17. 17. 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!!
  18. 18. 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
  19. 19. How? S Long Richemont Long put K= 18.22 Short call
  20. 20. 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
  21. 21. 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
  22. 22. 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
  23. 23. 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
  24. 24. 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
  25. 25. 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
  26. 26. 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
  27. 27. 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
  28. 28. Long preference shares K=675p Long put Synthetic call Short call Position: SQUARE The structure
  29. 29. 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
  30. 30. 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?
  31. 31. 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.
  32. 32. 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.
  33. 33. 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
  34. 34. 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.
  35. 35. 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.
  36. 36. S Long LTCM shares Short call Short synthetic put A clever deal?
  37. 37. 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
  38. 38. Hedgers and foxes  Equity derivatives can be used effectively by corporates to hedge certain contractual liabilities  Understand the risks involved
  39. 39. Contact and Disclaimer Dr Antonie Kotzé Email: 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.