Handbook of Corporate Equity Derivatives and Equity Capital Markets

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 xix1 Main Strategic Equity Derivative Instruments 11.1 Equity Forwards 11.1.1 Equity Forwards 11.1.2 Example of a Cash-settled Equity Forward on a Stock 21.1.3 Example of a Physically Settled Equity Forward on a Stock 31.1.4 Calculating the Forward Price of a Stock 41.2 Equity Swaps 61.2.1 Total Return Equity Swaps 61.2.2 Price Return Equity Swaps 71.2.3 Case Study: Physically Settled Total Return Equity Swap on Deutsche Telekom 71.2.4 Case Study: Cash-settled Total Return Equity Swap on Deutsche Telekom 121.2.5 Determination of the Initial Price 151.2.6 Determination of the Settlement Price 161.2.7 Equity Notional Resets 171.2.8 Case Study: Total Return Equity Swap on EuroStoxx 50 171.2.9 Compo Equity Swaps 211.2.10 Quanto Equity Swaps 231.2.11 Uses of Equity Swaps 251.3 Stock Lending and Borrowing 261.3.1 Stock Lending and Borrowing 261.3.2 Stock Lending/Borrowing Transaction Flows 271.3.3 Counterparty Credit Risk 281.3.4 Advantages of Stock Lending and Borrowing 291.3.5 Drawbacks of Stock Lending and Borrowing 291.4 Call and Put Options 301.4.1 Call Options 301.4.2 Put Options 331.4.3 European vs. American Style 361.4.4 Time Value vs. Intrinsic Value 361.4.5 In, At or Out-of-the-money 371.4.6 Variables that Influence an Option Price 381.4.7 Historical Volatility vs. Implied Volatility 401.4.8 Put–Call Parity 411.4.9 Options’ Sensitivities, the “Greeks” 421.4.10 Delta Hedging 441.4.11 Offsetting Dividend Risk 451.4.12 Adjustments to Option Terms Due to Other Corporate Actions 461.4.13 Volatility Smile 471.4.14 Implied Volatility Term Structure 481.4.15 Composite and Quanto Options 491.5 Dividend Swaps 501.5.1 Dividend Swaps 501.5.2 Applications of Dividend Swaps 501.5.3 Risks 521.5.4 Main Dates in a Dividend Distribution 521.5.5 Case Study: Single-stock Dividend Swap 521.5.6 Case Study: Index Dividend Swap 561.5.7 Pricing Implied Dividends 581.6 Variance Swaps and Volatility Swaps 581.6.1 Variance Swaps Product Description 591.6.2 Calculation of the Realized Volatility and the Realized Variance 611.6.3 Volatility Swaps Product Description 621.6.4 Volatility Swaps vs. Variance Swaps 631.6.5 Applications of Variance and Volatility Swaps 632 Equity Capital Markets Products 652.1 Main Equity Capital Markets Products 652.1.1 Capital Increase Products 652.1.2 Secondary Placement Products 662.1.3 Equity-linked Products 662.2 Initial Public Offerings 662.2.1 Product Description 662.2.2 Benefits of Going Public 672.2.3 Drawbacks of Going Public 672.2.4 The IPO Process 682.2.5 Phase 1: Preparation of the Company 682.2.6 Phase 2: Preparation of the Offering 692.2.7 Phase 3: Marketing of the Offering 752.2.8 Phase 4: Placement of the Offering 772.2.9 Key Success Factors Affecting an IPO 802.2.10 Key Risk Factors Affecting an IPO 812.2.11 Case Study: Visa’s IPO 822.3 Case Study: Google’s Dutch Auction IPO 852.4 Rights Issues (or Rights Offerings) 872.4.1 Product Description 872.4.2 Main Definitions of a Rights Issue 882.4.3 Advantages and Weaknesses of a Rights Issue 892.4.4 Rights Offerings Success Factors 902.4.5 Calculation of the TERP 902.4.6 Case Study: ING’s EUR 7.5 billion Rights Issue 912.5 Rights Issues of Convertible Bonds 952.5.1 Case Study: Banco Popolare Rights Issue of a Convertible Bond 952.6 Accelerated Book-Buildings 982.6.1 Product Description 982.6.2 Advantages and Weaknesses of an ABB 992.6.3 Estimating the Discount 992.6.4 Case Study: IPIC’s Disposal of 11.8% of Barclays 1002.7 At the Market Offerings 1002.7.1 Product Description 1002.7.2 Case Study: US Treasury Placement of Citigroup Shares 1013 Convertible Bonds and Mandatory Convertible Bonds 1033.1 Introduction to Convertible Bonds 1033.1.1 What are Convertible Bonds? 1033.1.2 Convertible vs. Exchangeable Bonds – Exchange Property 1043.2 Who Buys Convertible Bonds? 1053.3 Convertible Bonds: The Issuer Perspective 1063.4 Case Study: Infineon’s Convertible Bond 1073.4.1 Main Terms of Infineon’s Convertible Bond 1073.4.2 Conversion Price, Ratio, Premium and Lockout Period 1083.4.3 Hard No Call Period, Hard Call and Soft Call Options 1093.4.4 Put Rights 1103.4.5 Additional Clauses: Cash Option, Cash Top-up, Lock-up Period, Tax Call 1113.4.6 Value of a Convertible Bond at Maturity 1123.4.7 Value of a Convertible Bond during its Life 1123.5 Delta Share Repurchase Strategy 1143.6 Mandatory Convertible Bonds 1153.7 Rationale for Issuing Mandatory Convertibles 1153.8 Rationale for Investing in Mandatory Convertibles 1163.9 Fixed Parity Mandatory Convertibles 1163.9.1 Case Study: Banco Santander’s Fixed Parity Mandatory Convertible 1163.10 Variable Parity Mandatory Convertibles 1183.11 Dividend Enhanced Convertible Securities 1183.11.1 Conversion Mechanics of a DECS 1183.11.2 Anatomy of a DECS 1203.11.3 Embedded Derivatives in a DECS 1213.11.4 Pricing a DECS 1223.12 Case Study: UBS’s DECS 1223.13 Special Clauses in Convertibles 1243.13.1 Dividend Protection Clauses 1243.13.2 Coupon Deferral Clauses 1253.13.3 Call Option Make-whole Clauses 1263.13.4 Change-of-control Make-whole Clauses 1263.13.5 Clean-up Call Clauses 1273.13.6 Net Share Settlement Clauses 1273.14 Contingent Convertibles: FRESHES, CASHES and ECNS 1273.14.1 Case Study: Fortis’s FRESH Instrument 1283.14.2 Case Study: Unicredit’s CASHES Instrument 1313.14.3 Case Study: Lloyds ECN 1363.14.4 Case Study: Rabobank’s SCN 1394 Strategic Equity Transactions around Convertible/Exchangeable Bonds 1414.1 Issuing an Exchangeable with a Third-party Guarantee 1414.1.1 Case Study: Controlinveste’s Exchangeable Bonds on Portugal Telecom 1414.1.2 Transaction Overview 1424.1.3 Dividend Swap and Transaction Flows during the First Four Years 1434.1.4 Transaction Flows in Case of Exchanges or at Maturity 1454.1.5 Exchange Property Pledge and other Security Mechanisms 1464.1.6 Attractiveness of the Transaction to the Issuer and to BCP 1474.2 Issuing a Convertible Through a Third Party 1474.2.1 Case Study: Novartis LEPOs and Put Options with Deutsche Bank 1474.2.2 Transaction Overview 1474.2.3 Deutsche Bank’s Exposure to Novartis’s Stock Price 1494.2.4 Effect of Deutsche Bank’s Zero-coupon Convertibles on the Exchange Price 1514.2.5 Attractiveness of Deutsche Bank’s Zero-coupon Exchangeables to Investors 1524.2.6 Advantages to Novartis and Relevance of a Call Right 1524.3 Crystallizing a Gain in a Convertible Investment Through Warrants 1534.3.1 Case Study: Richemont Warrants Issue on Back of Convertible Preference Shares 1534.3.2 Warrants’ Terms 1544.3.3 Analysis of R&R’s Position 1544.3.4 Main Benefits to Richemont of the Warrants Issue 1554.3.5 Effect on BAT’s Stock Price of the Warrants Issue 1564.4 Monetizing a Stake with an Exchangeable Plus a Put 1564.4.1 Case Study: Deutsche Bank’s Exchangeable into Brisa 1564.4.2 Transaction Overview 1574.4.3 Analysis of Deutsche Bank’s Overall Position 1584.5 Increasing Likelihood of Conversion with a Call Spread 1614.5.1 Case Study: Chartered Semiconductor’s Call Spread with Goldman Sachs 1614.5.2 Goldman Sachs’s Overall Position 1624.5.3 CSM’s Overall Position 1634.5.4 Attractiveness of the Transaction to CSM 1664.5.5 Additional Remarks 1674.6 Decreasing Likelihood of Conversion with a Call Spread 1694.6.1 Case Study: Microsoft’s Convertible Plus Call Spread 1694.7 Double Issuance of Exchangeable Bonds 1694.7.1 Case Study: ABC’s Double Exchangeable 1694.8 Buying Back Conversion Rights 1724.8.1 Case Study: Cap Gemini’s Repurchase of Conversion Right from Société Générale 1724.9 Buying Back Convertible/Exchangeable Bonds 1754.9.1 Case Study: TUI’s Convertible Bond 1754.10 Pre-IPO Convertible Bonds 1785 Hedging and Yield Enhancing Strategic Stakes 1815.1 Hedging a Strategic Stake 1815.1.1 Hedging with a Put Option 1815.1.2 Hedging with a Put Spread 1845.1.3 Hedging with a Collar 1865.1.4 Hedging with a Put Spread Collar 1885.1.5 Hedging with a Fly Put Spread 1895.1.6 Hedging with a Knock-out Put 1915.1.7 Summary of Main Hedging Strategies 1935.1.8 Hedging with Ladder Puts 1935.1.9 Hedging with Variable Premium and Variable Expiry Timer Puts 1955.1.10 Hedging with Pay-later Puts 1975.2 Yield Enhancement of a Strategic Stake 1995.2.1 Lending the Stock 1995.2.2 Selling Part of the Upside with a Call 2005.2.3 Monetization of Dividend Optionality 2025.2.4 Reduction of Dividend Withholding Taxes with a Stock Lending Strategy 2045.2.5 Reduction of Dividend Withholding Taxes with a Converse Strategy 2056 Disposal of Strategic Stakes 2076.1 Most Common Disposal Strategies 2076.1.1 Case Study Assumptions 2076.1.2 Market Dribbling Out or Gradual Sale 2086.2 Deterministic Disposal Strategies 2096.2.1 ABB – Block Trade 2096.2.2 Mandatory Exchangeable Bond 2116.2.3 Indirect Issue of an Exchangeable Bond 2116.3 Enhanced Disposal Strategies 2126.3.1 Direct Issue of an Exchangeable Bond 2136.3.2 Sale of a Call Option 2146.3.3 One-speed Range Accrual 2166.3.4 Double-speed Range Accrual 2206.3.5 Double-speed Range Accrual with Final Call 2216.3.6 Double-speed Range Accrual with Deduction 2226.3.7 Double-speed Range Accrual with Knock-out 2226.4 Derecognition Strategies 2246.4.1 Sale + Cash-settled Equity Swap 2246.4.2 Physically Settled Equity Swap + Call Option 2276.5 Combination of ABB and a Call Option/Exchangeable 2296.5.1 Case Study: Germany’s Disposal of Fraport with JP Morgan’s Collaboration 2297 Strategic Equity Derivatives in Mergers and Acquisitions 2357.1 Keeping Voting Rights in Proxy Contests 2377.1.1 Case Study: Montalban Partners’ Disposal of Gold International 2377.2 Submitting Resolutions to an AGM 2397.2.1 Case Study: Laxey’s Stock Lending Transaction 2407.3 Increasing Likelihood of Success of a Merger Arbitrage Position 2427.3.1 Case Study: Perry’s Equity Swaps with Bear Stearns and Goldman Sachs 2427.4 Avoiding Mandatory Offer Rules 2477.4.1 Case Study: Agnelli Family Equity Swap with Merrill Lynch 2477.5 Increasing Likelihood of Success of a Takeover 2517.5.1 Case Study: Unipol’s Takeover of BNL and Call/Put Combination with Deutsche Bank 2518 Stock Options Plans Hedging 2578.1 Main Equity-based Compensation Plans 2578.1.1 Main Equity-based Compensation Plans 2578.1.2 Terminology of Stock Option Plans and SARs 2588.2 IFRS Accounting for Equity-based Compensation Plans 2598.2.1 Accounting for Stock Options Plans 2618.2.2 Accounting for Stock Appreciation Rights 2638.3 Case Study: ABC’s ESOP and SAR 2658.3.1 Main Terms of ABC’s ESOP and SAR 2658.3.2 Accounting for ABC’s ESOP 2668.3.3 Accounting for ABC’s SAR 2708.4 Main ESOP/SAR Hedging Strategies 2738.4.1 Underlying Risks in ESOPs and SARs 2738.4.2 Hedging with Treasury Shares 2748.4.3 Hedging with Equity Swaps 2758.4.4 Hedging a SAR with an Enhanced Equity Swap 2798.4.5 Hedging with Standard Call Options 2808.4.6 Hedging with Auto Call Options 2828.4.7 Hedging with Timer Call Options 2828.5 HSBC’s Performance Share Plan 2838.5.1 Terms of HSBC’s Performance Share Plan 2838.5.2 Accounting for the Plan 2848.5.3 Hedging the Plan 2859 Equity Financings 2879.1 Case Study: Equity Collateralized Bond 2879.1.1 Bond Terms 2879.1.2 Main Documents of the Financing 2889.1.3 Parties to an Equity Financing 2899.1.4 Accounts in an Equity Financing 2909.1.5 Credit Enhancement Tools 2919.1.6 Early Termination Events 2929.1.7 Events of Default 2959.1.8 Syndicating the Equity Financing with a Credit Default Swap 2979.1.9 Recourse vs. Non-recourse Equity Financings 2999.2 Sale + Equity Swap 3009.2.1 Transaction Description 3009.2.2 Equity Swap Terms 3009.2.3 Equity Swap Flows 3059.2.4 Advantages and Weaknesses 3079.3 Prepaid Forward + Equity Swap + Pledge 3089.3.1 Product Description 3089.3.2 Equity Derivatives Terms 3089.3.3 Transaction Flows 3149.3.4 Advantages and Weaknesses 3169.4 Repo Financing 3169.4.1 Product Description 3169.5 Stock Loan Financing 3179.5.1 Product Description 3179.6 Put Financing 3189.6.1 Product Description 3189.6.2 Advantages and Weaknesses 3199.7 Collared Financing 3209.7.1 Product Description 3209.7.2 Advantages and Weaknesses 3219.8 Revolving Margin Loan Facilities 3229.8.1 Case Study: Oil SPE’s Revolving Margin Loan Facility 32210 Share Buybacks and Other Transactions on Treasury Shares 32710.1 Open Market Repurchase Programs 32710.2 Accelerated Repurchase Programs 32910.2.1 Case Study: Hewlett Packard’s ASR with Merrill Lynch 32910.3 VWAP-Linked Repurchase Programs 33210.3.1 Execution on a Best Effort Basis 33210.3.2 Execution on a Guaranteed Basis 33310.3.3 Advantages and Weaknesses of a VWAP-linked Strategy 33310.3.4 Execution at a Discounted VWAP 33410.3.5 Execution at a Capped VWAP 33710.4 Prepaid Collared Repurchase Programs 33810.4.1 Case Study: Hewlett Packard’s PCRP with BNP Paribas 33910.5 Deep-in-the-money Call Purchase 34010.5.1 Case Study: ABC’s Acquisition of a Deep-in-the-money Call Option 34110.6 Asian Call Purchase 34310.7 Publicly Offered Repurchase Programs 34510.7.1 Case Study: Corporacion Dermoestetica’s Public Offer to Acquire Own Shares 34510.8 Public Offer of Put Options 34610.8.1 Case Study: Swisscom’s Public Offer of Put Options 34610.9 Private Sale of a Put Option 34710.10 Acquisition of Shares with a Range Accrual 34810.10.1 One-speed Range Accrual 34810.10.2 Double-speed Range Accrual 35210.10.3 Double-speed Range Accrual with Final Put 35410.11 Other Transactions on Treasury Shares 35510.11.1 Case Study: ABC’s Restructuring of Call on Own Shares 35510.11.2 Case Study: Gilead’s Share Repurchase Program Financed with Convertible Bonds 36111 Bank Regulatory Capital 36511.1 An Overview of Basel III 36511.1.1 Precedent Bank Regulatory Capital Accords 36511.1.2 The Capital Ratio 36611.1.3 Bank Regulatory Capital 36711.1.4 Risk-weighted Assets 36711.2 Tier 1 Capital 36911.2.1 Common Equity Tier 1 Capital 36911.2.2 Additional Tier 1 Capital 37311.3 Tier 2 Capital 37611.3.1 Criteria for Inclusion in Tier 2 Capital 37611.3.2 Trigger Conditions for Hybrid Instruments 37911.4 Deductions from Common Equity Tier 1 Capital 38011.4.1 Goodwill and Other Intangible Assets (Except Mortgage Servicing Rights) 38011.4.2 Deferred Tax Assets 38011.4.3 Cash Flow Hedge Reserve 38211.4.4 Shortfall of the Stock of Provisions to Expected Losses 38311.4.5 Gain-on-sale Related to Securitization Transactions 38311.4.6 Gains and Losses on Fair Valued Own Liabilities due to Changes in Own Credit Risk 38311.4.7 Defined Benefit Pension Fund Assets and Liabilities 38311.4.8 Treasury Stock 38511.4.9 Reciprocal Stakes in Unconsolidated Financial Companies 38511.4.10 Less than 10% Stakes in Unconsolidated Financial Companies 38511.4.11 Significant Stakes in Unconsolidated Financial Companies 38711.4.12 Combined Deduction of Significant Investments in Unconsolidated Financial Entities, MSRs and DTAs 38811.4.13 Basel II 50/50 Deductions 38911.5 Other Capital Buffers 38911.5.1 Capital Conservation Buffer 38911.5.2 Countercyclical Buffer 39111.6 Transitional Arrangements 39211.6.1 Transitional Period 39211.6.2 Capital Instruments Failing Criteria for Eligibility in Capital 39311.7 Leverage Ratio 39311.8 Liquidity Coverage Ratio 39411.9 Net Stable Funding Ratio 39611.10 Case Study: Calculation of Minority Interests 39711.11 Case Study: Creating Minority Interests 39911.12 Case Study: Reducing Risk Weighting 40111.13 Case Study: Releasing Common Equity 40111.14 Case Study: Reducing an Unconsolidated Financial Stake 40311.15 Case Study: Commerzbank’s Capital Structure Enhancement with Credit Suisse 404Bibliography 407Index 409