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Handbook of Corporate Equity Derivatives and Equity Capital Markets

by: Ramirez, Juan

Handbook of Corporate Equity Derivatives and Equity Capital Markets

by: Ramirez, Juan

ISBN 13:
9781119975908
ISBN 10:
1119975905
Edition: 1st
Format: Hardcover
Copyright: 08/29/2011
Publisher: Wiley

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Summary

Handbook of Strategic Equity Derivatives and Equity Markets is a unique, fully self-contained guide to building and implementing an equity derivatives strategy. Equity strategies are closely guarded secrets and as such, there is very little written about how investors and corporate can utilise equity vehicles as part of their growth strategies. In this much-needed book, industry expert Juan Ramiraz guides readers through the whole range of equity derivative instruments, showing how they can be applied to a range of equity capital market situations, including hedging, yield enhancement and disposal of strategic stakes, mergers and acquisitions, stock options plan hedging, equity financings, share buybacks and other transactions on treasury shares, bank regulatory capital arbitrage and tax driven situations. The book includes case studies to highlight how equity derivative strategies have been used in real life situations.

Author Biography

JUAN RAMIREZ currently works in an international bank and is responsible for the marketing of strategic derivatives to Iberian corporate and institutional clients. After earning a bachelor degree in electrical engineering at the ICAI University in Madrid, he joined the consumer products group at Arthur Andersen where he spent five years gaining a substantial exposure to the accounting world. After earning an MBA degree from University of Chicago, Mr. Ramirez moved to London to work at Chase Manhatten(currently JP Morgan). He has also working at Lehman Brothers, Barclays Capital and Banco Santander. Mr. Ramirez has devoted more than 15 years marketing structured derivatives solutions. During the last seven years he has been working in strategic equity transactions with a strong accounting, capital markets, tax and regulatory angle. Mr. Ramirez is married and has three childen.

Preface xvii

About the Author xix

1 Main Strategic Equity Derivative Instruments 1

1.1 Equity Forwards 1

1.1.1 Equity Forwards 1

1.1.2 Example of a Cash-settled Equity Forward on a Stock 2

1.1.3 Example of a Physically Settled Equity Forward on a Stock 3

1.1.4 Calculating the Forward Price of a Stock 4

1.2 Equity Swaps 6

1.2.1 Total Return Equity Swaps 6

1.2.2 Price Return Equity Swaps 7

1.2.3 Case Study: Physically Settled Total Return Equity Swap on Deutsche Telekom 7

1.2.4 Case Study: Cash-settled Total Return Equity Swap on Deutsche Telekom 12

1.2.5 Determination of the Initial Price 15

1.2.6 Determination of the Settlement Price 16

1.2.7 Equity Notional Resets 17

1.2.8 Case Study: Total Return Equity Swap on EuroStoxx 50 17

1.2.9 Compo Equity Swaps 21

1.2.10 Quanto Equity Swaps 23

1.2.11 Uses of Equity Swaps 25

1.3 Stock Lending and Borrowing 26

1.3.1 Stock Lending and Borrowing 26

1.3.2 Stock Lending/Borrowing Transaction Flows 27

1.3.3 Counterparty Credit Risk 28

1.3.4 Advantages of Stock Lending and Borrowing 29

1.3.5 Drawbacks of Stock Lending and Borrowing 29

1.4 Call and Put Options 30

1.4.1 Call Options 30

1.4.2 Put Options 33

1.4.3 European vs. American Style 36

1.4.4 Time Value vs. Intrinsic Value 36

1.4.5 In, At or Out-of-the-money 37

1.4.6 Variables that Influence an Option Price 38

1.4.7 Historical Volatility vs. Implied Volatility 40

1.4.8 Put–Call Parity 41

1.4.9 Options’ Sensitivities, the “Greeks” 42

1.4.10 Delta Hedging 44

1.4.11 Offsetting Dividend Risk 45

1.4.12 Adjustments to Option Terms Due to Other Corporate Actions 46

1.4.13 Volatility Smile 47

1.4.14 Implied Volatility Term Structure 48

1.4.15 Composite and Quanto Options 49

1.5 Dividend Swaps 50

1.5.1 Dividend Swaps 50

1.5.2 Applications of Dividend Swaps 50

1.5.3 Risks 52

1.5.4 Main Dates in a Dividend Distribution 52

1.5.5 Case Study: Single-stock Dividend Swap 52

1.5.6 Case Study: Index Dividend Swap 56

1.5.7 Pricing Implied Dividends 58

1.6 Variance Swaps and Volatility Swaps 58

1.6.1 Variance Swaps Product Description 59

1.6.2 Calculation of the Realized Volatility and the Realized Variance 61

1.6.3 Volatility Swaps Product Description 62

1.6.4 Volatility Swaps vs. Variance Swaps 63

1.6.5 Applications of Variance and Volatility Swaps 63

2 Equity Capital Markets Products 65

2.1 Main Equity Capital Markets Products 65

2.1.1 Capital Increase Products 65

2.1.2 Secondary Placement Products 66

2.1.3 Equity-linked Products 66

2.2 Initial Public Offerings 66

2.2.1 Product Description 66

2.2.2 Benefits of Going Public 67

2.2.3 Drawbacks of Going Public 67

2.2.4 The IPO Process 68

2.2.5 Phase 1: Preparation of the Company 68

2.2.6 Phase 2: Preparation of the Offering 69

2.2.7 Phase 3: Marketing of the Offering 75

2.2.8 Phase 4: Placement of the Offering 77

2.2.9 Key Success Factors Affecting an IPO 80

2.2.10 Key Risk Factors Affecting an IPO 81

2.2.11 Case Study: Visa’s IPO 82

2.3 Case Study: Google’s Dutch Auction IPO 85

2.4 Rights Issues (or Rights Offerings) 87

2.4.1 Product Description 87

2.4.2 Main Definitions of a Rights Issue 88

2.4.3 Advantages and Weaknesses of a Rights Issue 89

2.4.4 Rights Offerings Success Factors 90

2.4.5 Calculation of the TERP 90

2.4.6 Case Study: ING’s EUR 7.5 billion Rights Issue 91

2.5 Rights Issues of Convertible Bonds 95

2.5.1 Case Study: Banco Popolare Rights Issue of a Convertible Bond 95

2.6 Accelerated Book-Buildings 98

2.6.1 Product Description 98

2.6.2 Advantages and Weaknesses of an ABB 99

2.6.3 Estimating the Discount 99

2.6.4 Case Study: IPIC’s Disposal of 11.8% of Barclays 100

2.7 At the Market Offerings 100

2.7.1 Product Description 100

2.7.2 Case Study: US Treasury Placement of Citigroup Shares 101

3 Convertible Bonds and Mandatory Convertible Bonds 103

3.1 Introduction to Convertible Bonds 103

3.1.1 What are Convertible Bonds? 103

3.1.2 Convertible vs. Exchangeable Bonds – Exchange Property 104

3.2 Who Buys Convertible Bonds? 105

3.3 Convertible Bonds: The Issuer Perspective 106

3.4 Case Study: Infineon’s Convertible Bond 107

3.4.1 Main Terms of Infineon’s Convertible Bond 107

3.4.2 Conversion Price, Ratio, Premium and Lockout Period 108

3.4.3 Hard No Call Period, Hard Call and Soft Call Options 109

3.4.4 Put Rights 110

3.4.5 Additional Clauses: Cash Option, Cash Top-up, Lock-up Period, Tax Call 111

3.4.6 Value of a Convertible Bond at Maturity 112

3.4.7 Value of a Convertible Bond during its Life 112

3.5 Delta Share Repurchase Strategy 114

3.6 Mandatory Convertible Bonds 115

3.7 Rationale for Issuing Mandatory Convertibles 115

3.8 Rationale for Investing in Mandatory Convertibles 116

3.9 Fixed Parity Mandatory Convertibles 116

3.9.1 Case Study: Banco Santander’s Fixed Parity Mandatory Convertible 116

3.10 Variable Parity Mandatory Convertibles 118

3.11 Dividend Enhanced Convertible Securities 118

3.11.1 Conversion Mechanics of a DECS 118

3.11.2 Anatomy of a DECS 120

3.11.3 Embedded Derivatives in a DECS 121

3.11.4 Pricing a DECS 122

3.12 Case Study: UBS’s DECS 122

3.13 Special Clauses in Convertibles 124

3.13.1 Dividend Protection Clauses 124

3.13.2 Coupon Deferral Clauses 125

3.13.3 Call Option Make-whole Clauses 126

3.13.4 Change-of-control Make-whole Clauses 126

3.13.5 Clean-up Call Clauses 127

3.13.6 Net Share Settlement Clauses 127

3.14 Contingent Convertibles: FRESHES, CASHES and ECNS 127

3.14.1 Case Study: Fortis’s FRESH Instrument 128

3.14.2 Case Study: Unicredit’s CASHES Instrument 131

3.14.3 Case Study: Lloyds ECN 136

3.14.4 Case Study: Rabobank’s SCN 139

4 Strategic Equity Transactions around Convertible/Exchangeable Bonds 141

4.1 Issuing an Exchangeable with a Third-party Guarantee 141

4.1.1 Case Study: Controlinveste’s Exchangeable Bonds on Portugal Telecom 141

4.1.2 Transaction Overview 142

4.1.3 Dividend Swap and Transaction Flows during the First Four Years 143

4.1.4 Transaction Flows in Case of Exchanges or at Maturity 145

4.1.5 Exchange Property Pledge and other Security Mechanisms 146

4.1.6 Attractiveness of the Transaction to the Issuer and to BCP 147

4.2 Issuing a Convertible Through a Third Party 147

4.2.1 Case Study: Novartis LEPOs and Put Options with Deutsche Bank 147

4.2.2 Transaction Overview 147

4.2.3 Deutsche Bank’s Exposure to Novartis’s Stock Price 149

4.2.4 Effect of Deutsche Bank’s Zero-coupon Convertibles on the Exchange Price 151

4.2.5 Attractiveness of Deutsche Bank’s Zero-coupon Exchangeables to Investors 152

4.2.6 Advantages to Novartis and Relevance of a Call Right 152

4.3 Crystallizing a Gain in a Convertible Investment Through Warrants 153

4.3.1 Case Study: Richemont Warrants Issue on Back of Convertible Preference Shares 153

4.3.2 Warrants’ Terms 154

4.3.3 Analysis of R&R’s Position 154

4.3.4 Main Benefits to Richemont of the Warrants Issue 155

4.3.5 Effect on BAT’s Stock Price of the Warrants Issue 156

4.4 Monetizing a Stake with an Exchangeable Plus a Put 156

4.4.1 Case Study: Deutsche Bank’s Exchangeable into Brisa 156

4.4.2 Transaction Overview 157

4.4.3 Analysis of Deutsche Bank’s Overall Position 158

4.5 Increasing Likelihood of Conversion with a Call Spread 161

4.5.1 Case Study: Chartered Semiconductor’s Call Spread with Goldman Sachs 161

4.5.2 Goldman Sachs’s Overall Position 162

4.5.3 CSM’s Overall Position 163

4.5.4 Attractiveness of the Transaction to CSM 166

4.5.5 Additional Remarks 167

4.6 Decreasing Likelihood of Conversion with a Call Spread 169

4.6.1 Case Study: Microsoft’s Convertible Plus Call Spread 169

4.7 Double Issuance of Exchangeable Bonds 169

4.7.1 Case Study: ABC’s Double Exchangeable 169

4.8 Buying Back Conversion Rights 172

4.8.1 Case Study: Cap Gemini’s Repurchase of Conversion Right from Société Générale 172

4.9 Buying Back Convertible/Exchangeable Bonds 175

4.9.1 Case Study: TUI’s Convertible Bond 175

4.10 Pre-IPO Convertible Bonds 178

5 Hedging and Yield Enhancing Strategic Stakes 181

5.1 Hedging a Strategic Stake 181

5.1.1 Hedging with a Put Option 181

5.1.2 Hedging with a Put Spread 184

5.1.3 Hedging with a Collar 186

5.1.4 Hedging with a Put Spread Collar 188

5.1.5 Hedging with a Fly Put Spread 189

5.1.6 Hedging with a Knock-out Put 191

5.1.7 Summary of Main Hedging Strategies 193

5.1.8 Hedging with Ladder Puts 193

5.1.9 Hedging with Variable Premium and Variable Expiry Timer Puts 195

5.1.10 Hedging with Pay-later Puts 197

5.2 Yield Enhancement of a Strategic Stake 199

5.2.1 Lending the Stock 199

5.2.2 Selling Part of the Upside with a Call 200

5.2.3 Monetization of Dividend Optionality 202

5.2.4 Reduction of Dividend Withholding Taxes with a Stock Lending Strategy 204

5.2.5 Reduction of Dividend Withholding Taxes with a Converse Strategy 205

6 Disposal of Strategic Stakes 207

6.1 Most Common Disposal Strategies 207

6.1.1 Case Study Assumptions 207

6.1.2 Market Dribbling Out or Gradual Sale 208

6.2 Deterministic Disposal Strategies 209

6.2.1 ABB – Block Trade 209

6.2.2 Mandatory Exchangeable Bond 211

6.2.3 Indirect Issue of an Exchangeable Bond 211

6.3 Enhanced Disposal Strategies 212

6.3.1 Direct Issue of an Exchangeable Bond 213

6.3.2 Sale of a Call Option 214

6.3.3 One-speed Range Accrual 216

6.3.4 Double-speed Range Accrual 220

6.3.5 Double-speed Range Accrual with Final Call 221

6.3.6 Double-speed Range Accrual with Deduction 222

6.3.7 Double-speed Range Accrual with Knock-out 222

6.4 Derecognition Strategies 224

6.4.1 Sale + Cash-settled Equity Swap 224

6.4.2 Physically Settled Equity Swap + Call Option 227

6.5 Combination of ABB and a Call Option/Exchangeable 229

6.5.1 Case Study: Germany’s Disposal of Fraport with JP Morgan’s Collaboration 229

7 Strategic Equity Derivatives in Mergers and Acquisitions 235

7.1 Keeping Voting Rights in Proxy Contests 237

7.1.1 Case Study: Montalban Partners’ Disposal of Gold International 237

7.2 Submitting Resolutions to an AGM 239

7.2.1 Case Study: Laxey’s Stock Lending Transaction 240

7.3 Increasing Likelihood of Success of a Merger Arbitrage Position 242

7.3.1 Case Study: Perry’s Equity Swaps with Bear Stearns and Goldman Sachs 242

7.4 Avoiding Mandatory Offer Rules 247

7.4.1 Case Study: Agnelli Family Equity Swap with Merrill Lynch 247

7.5 Increasing Likelihood of Success of a Takeover 251

7.5.1 Case Study: Unipol’s Takeover of BNL and Call/Put Combination with Deutsche Bank 251

8 Stock Options Plans Hedging 257

8.1 Main Equity-based Compensation Plans 257

8.1.1 Main Equity-based Compensation Plans 257

8.1.2 Terminology of Stock Option Plans and SARs 258

8.2 IFRS Accounting for Equity-based Compensation Plans 259

8.2.1 Accounting for Stock Options Plans 261

8.2.2 Accounting for Stock Appreciation Rights 263

8.3 Case Study: ABC’s ESOP and SAR 265

8.3.1 Main Terms of ABC’s ESOP and SAR 265

8.3.2 Accounting for ABC’s ESOP 266

8.3.3 Accounting for ABC’s SAR 270

8.4 Main ESOP/SAR Hedging Strategies 273

8.4.1 Underlying Risks in ESOPs and SARs 273

8.4.2 Hedging with Treasury Shares 274

8.4.3 Hedging with Equity Swaps 275

8.4.4 Hedging a SAR with an Enhanced Equity Swap 279

8.4.5 Hedging with Standard Call Options 280

8.4.6 Hedging with Auto Call Options 282

8.4.7 Hedging with Timer Call Options 282

8.5 HSBC’s Performance Share Plan 283

8.5.1 Terms of HSBC’s Performance Share Plan 283

8.5.2 Accounting for the Plan 284

8.5.3 Hedging the Plan 285

9 Equity Financings 287

9.1 Case Study: Equity Collateralized Bond 287

9.1.1 Bond Terms 287

9.1.2 Main Documents of the Financing 288

9.1.3 Parties to an Equity Financing 289

9.1.4 Accounts in an Equity Financing 290

9.1.5 Credit Enhancement Tools 291

9.1.6 Early Termination Events 292

9.1.7 Events of Default 295

9.1.8 Syndicating the Equity Financing with a Credit Default Swap 297

9.1.9 Recourse vs. Non-recourse Equity Financings 299

9.2 Sale + Equity Swap 300

9.2.1 Transaction Description 300

9.2.2 Equity Swap Terms 300

9.2.3 Equity Swap Flows 305

9.2.4 Advantages and Weaknesses 307

9.3 Prepaid Forward + Equity Swap + Pledge 308

9.3.1 Product Description 308

9.3.2 Equity Derivatives Terms 308

9.3.3 Transaction Flows 314

9.3.4 Advantages and Weaknesses 316

9.4 Repo Financing 316

9.4.1 Product Description 316

9.5 Stock Loan Financing 317

9.5.1 Product Description 317

9.6 Put Financing 318

9.6.1 Product Description 318

9.6.2 Advantages and Weaknesses 319

9.7 Collared Financing 320

9.7.1 Product Description 320

9.7.2 Advantages and Weaknesses 321

9.8 Revolving Margin Loan Facilities 322

9.8.1 Case Study: Oil SPE’s Revolving Margin Loan Facility 322

10 Share Buybacks and Other Transactions on Treasury Shares 327

10.1 Open Market Repurchase Programs 327

10.2 Accelerated Repurchase Programs 329

10.2.1 Case Study: Hewlett Packard’s ASR with Merrill Lynch 329

10.3 VWAP-Linked Repurchase Programs 332

10.3.1 Execution on a Best Effort Basis 332

10.3.2 Execution on a Guaranteed Basis 333

10.3.3 Advantages and Weaknesses of a VWAP-linked Strategy 333

10.3.4 Execution at a Discounted VWAP 334

10.3.5 Execution at a Capped VWAP 337

10.4 Prepaid Collared Repurchase Programs 338

10.4.1 Case Study: Hewlett Packard’s PCRP with BNP Paribas 339

10.5 Deep-in-the-money Call Purchase 340

10.5.1 Case Study: ABC’s Acquisition of a Deep-in-the-money Call Option 341

10.6 Asian Call Purchase 343

10.7 Publicly Offered Repurchase Programs 345

10.7.1 Case Study: Corporacion Dermoestetica’s Public Offer to Acquire Own Shares 345

10.8 Public Offer of Put Options 346

10.8.1 Case Study: Swisscom’s Public Offer of Put Options 346

10.9 Private Sale of a Put Option 347

10.10 Acquisition of Shares with a Range Accrual 348

10.10.1 One-speed Range Accrual 348

10.10.2 Double-speed Range Accrual 352

10.10.3 Double-speed Range Accrual with Final Put 354

10.11 Other Transactions on Treasury Shares 355

10.11.1 Case Study: ABC’s Restructuring of Call on Own Shares 355

10.11.2 Case Study: Gilead’s Share Repurchase Program Financed with Convertible Bonds 361

11 Bank Regulatory Capital 365

11.1 An Overview of Basel III 365

11.1.1 Precedent Bank Regulatory Capital Accords 365

11.1.2 The Capital Ratio 366

11.1.3 Bank Regulatory Capital 367

11.1.4 Risk-weighted Assets 367

11.2 Tier 1 Capital 369

11.2.1 Common Equity Tier 1 Capital 369

11.2.2 Additional Tier 1 Capital 373

11.3 Tier 2 Capital 376

11.3.1 Criteria for Inclusion in Tier 2 Capital 376

11.3.2 Trigger Conditions for Hybrid Instruments 379

11.4 Deductions from Common Equity Tier 1 Capital 380

11.4.1 Goodwill and Other Intangible Assets (Except Mortgage Servicing Rights) 380

11.4.2 Deferred Tax Assets 380

11.4.3 Cash Flow Hedge Reserve 382

11.4.4 Shortfall of the Stock of Provisions to Expected Losses 383

11.4.5 Gain-on-sale Related to Securitization Transactions 383

11.4.6 Gains and Losses on Fair Valued Own Liabilities due to Changes in Own Credit Risk 383

11.4.7 Defined Benefit Pension Fund Assets and Liabilities 383

11.4.8 Treasury Stock 385

11.4.9 Reciprocal Stakes in Unconsolidated Financial Companies 385

11.4.10 Less than 10% Stakes in Unconsolidated Financial Companies 385

11.4.11 Significant Stakes in Unconsolidated Financial Companies 387

11.4.12 Combined Deduction of Significant Investments in Unconsolidated Financial Entities, MSRs and DTAs 388

11.4.13 Basel II 50/50 Deductions 389

11.5 Other Capital Buffers 389

11.5.1 Capital Conservation Buffer 389

11.5.2 Countercyclical Buffer 391

11.6 Transitional Arrangements 392

11.6.1 Transitional Period 392

11.6.2 Capital Instruments Failing Criteria for Eligibility in Capital 393

11.7 Leverage Ratio 393

11.8 Liquidity Coverage Ratio 394

11.9 Net Stable Funding Ratio 396

11.10 Case Study: Calculation of Minority Interests 397

11.11 Case Study: Creating Minority Interests 399

11.12 Case Study: Reducing Risk Weighting 401

11.13 Case Study: Releasing Common Equity 401

11.14 Case Study: Reducing an Unconsolidated Financial Stake 403

11.15 Case Study: Commerzbank’s Capital Structure Enhancement with Credit Suisse 404

Bibliography 407

Index 409

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