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Abenaa AmpratwumCases in DerivativesCase Write-upWeek 6

Advanced Material Case

1. What is the risk to AMT of issuing debt in currencies other than yen? Why might the

company choose to denominate debt in the currency of a country in which it sells a lotof products?

Exchange rate risk is the risk that a business' operations or an investment's value will be

affected b changes in exchange rates! "here is exchange rate risk for A#"! "he reason wh

a compan might choose to denominate debt in the currenc of a countr in which it sells a lot

of product$ in this case A#" a %apanese compan sells a lot of product in America&

f dollar appreciates against the en$ A#C would pa more to service their debt!

"here are man restrictive regulations on debt issues in %apan!

(nderwriting fees charged b %apanese govt! is too high as compared to underwriting

fees charged in other countries!

. !ow can the firm "hedge# the issuance of bonds denominated in a foreign currency?

Why is it difficult to hedge convertible bonds denominated in foreign currencies?

A firm can hedge the issuance of bonds denominated in foreign currenc b swapping en for

dollar bonds! f conversion from debt to e)uit doesn*t take place in a short period after

issuance$ issuers have to bear a high risk when their convertible bond matures$ making it

difficult to hedge convertible bonds denominated in foreign currenc! Alternativel$ a forward

contract can also be entered but this is difficult to execute! f it existed$ the +,r forward

contract would have a high interest rate and ver poor terms! f the forward contract existed in

the market$ it would depend on interest rates for both countries! n both cases$ it is ver risk

to hedge because of inflation and or change in bases over time! "he uncertaint causes

)uantit risk therefore there is no perfect hedge!

$. %&plain how a convertible bond "works.# Why might a firm want to issue convertiblebonds? Why would someone want to convert the bond? What is relin'uished upon

conversion and what is received?

Convertible debentures allow debenture holders the right to convert their bonds into the

common stock of the issuer corporation! ow a debenture is converted into a stock depends

on certain conversion features! Conversion features consist of a conversion price$ which is

established at the point of issuance and determines the number of shares of common stock a

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debenture holder will receive upon conversion$ and a conversion ratio$ which is the actual

number of shares received! Conversion features ma also change in the event of a stock split

or stock dividend! .or stock splits$ the conversion ratio would change b ad/usting the

conversion price of the stock with the corresponding split! Additionall$ for stock dividends$

the conversion ratio would increase b the corresponding percentage dividend! 0ne of the

advantages to issuing convertible bonds over non-convertible bonds is that issuing

corporations can borrow funds at a lower interest rate! .or bondholders$ the benefits of

preferred placement for li)uidation rights$ and the flexibilit of conversion in the event of a

stock price increase$ is greater than the receipt of a lower interest rate! Conversel$ some of

the disadvantages to convertible bonds are the possibilit of earnings dilution in the event that

all convertible bonds are converted at one time$ and the possible tax implications on pre-tax

earnings distributions! Convertibilit affects the performance of the bond in certain was! .irst

and foremost$ convertible bonds tend to have lower interest rates than non-convertibles

because the also accrue value as the price of the underling stock rises! "herefore$convertible bonds offer some of the benefits of both stocks and bonds! Convertibles earn

interest even when the stock is trading down or sidewas$ but when the stock prices rises$ the

value of the convertible increases! Convertibles are an excellent choice for investors looking

for capital appreciation$ while still protecting their original investment in a bond! While C1s do

provide some income$ it's not ver high! nvestors give up higher returns on the bond in

exchange for the option to convert into shares at a later date!

(. )s it likely that someone will convert the bond prior to the e&piration of the

conversion feature *which usually corresponds to the maturity of the bond+? Why orwhy not?

t is not normall optimal for an investor to convert a convertible bond to e)uit prior to

maturit! "he lower limit to the value of a convertible debt instrument is the higher of its bond

value or conversion value! "he value of a convertible instrument before its maturit is

normall worth more than its lower limit if the issuer cannot call the instrument! "he value of a

convertible before maturit less the value of its lower limit represents the value of a call option

on the stock of the issuer! "he investor must give up the bond in order to exercise the call

option so the bond value serves as the exercise price! When conversion occurs$ the bond

value exchanged for e)uit shares 2that is$ the exercise price of the call option3 becomes at

risk to declines in the share price of the issuer! 4rior to conversion$ the bond value serves as

a floor to the value of the hbrid instrument! Additionall$ the holder of a convertible bond

loses an time value associated with its call option if conversion occurs prior to maturit!

#ost professional investors don't plan to convert their bonds to stock! "he hold the bond and

collect the income while$ if all goes well$ the convertible's value goes up as the stock

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appreciates! Convertibles normall behave as follows& When the underling stock advances$

the convertibles gain value too$ /ust not as much as the stock! When the stock falls$ interest

income cushions the loss! "he nature of the beast is that these are less volatile than straight

stocks! "he onl reason an investor would exercise a convertible earl is to capture dividends

which must be higher than leverage and insurance value!

,. What is the difference between a convertible bond and a straight bond with a warrant?

!ow might the relationship between interest rates and stock prices affect the relativevalue of the two?

"he difference is that convertible bond would cease to exist after the conversion i!e! it is

replace b the common stock whereas for straight bond with a warrant the investor continues

to hold on to the bond but additionall receives common stock! 5ond prices are inversel

correlated to interest rates! When interest rates go up$ bond prices go down and when

interest rates go down$ bond prices go up! tock and 5onds are directl correlated and ma

be higher if stocks and bonds are from the same compan! t does not make a difference

unless the convertible is a forced conversion! n this case the straight bond with a warrant is

more valuable! olding both however$ provides more volatilit meaning higher returns!

-. ased on the interest rate graph presented on page 1/0 what0 superficially0 looks to be

the cheapest currency in which to denominate the debt? What is the concept of

covered interest parity? !ow does it affect your earlier answer to this 'uestion?

n the short term i!e! 7-6 months ( Dollar looks cheaper! 5ut for the long term$ the %apanese

en looks cheaper! According to the covered interest rate parit the difference in the interest

rate observed is compensated b the exchange rate differential between two currencies! "he

transaction costs take care of the rest! 8ow as per this theor debt in both currencies appears

similar i!e! covered interest parit enforced b arbitrage! (ncovered nterest 4arit means

when a compan does not hedge$ a profit and a loss can be incurred i!e! 9en carr trade

didn*t believe in uncovered interest parit!

. Make a suggestion on what form of debt should that used the currency in which it

should be denominated.

:ooking at complications$ A#C should go ahead with the issuance of traight bonds in the

Eurodollar market because the are hedged in that market!