THE PRACTICAL APPLICATION OF EQUITY DERIVATIVES FOR CORPORATES

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. 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. 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. What’s in it for corporates?
Derivatives expanded the
universe of
instruments available
for trading and
hedging

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. Black-Scholes through the eyes of.....
Let’s demistify options

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. 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. The Formulas
• Future
• Option

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. 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. 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. 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. 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. 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. 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. 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. 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. How?
S
Long
Richemont
Long
put
K= 18.22
Short
call

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. 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. 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. 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. 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. 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. 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. 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. Long
preference
shares
K=675p
Long
put
Synthetic
call
Short
call
Position:
SQUARE
The structure

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. 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. 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. 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. 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. 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. 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. S
Long LTCM
shares
Short
call
Short
synthetic
put
A clever deal?

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. Hedgers and foxes
 Equity derivatives can be used
effectively by corporates to
hedge certain contractual
liabilities
 Understand the risks involved

39. Contact and Disclaimer
Dr Antonie Kotzé
Email: antonie@quantonline.co.za
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.