structured products hybrids

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Structured ProductsHybrids

October 2004

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Structured Products & Hybrids

• Linked Instruments

• Cross-Market Transactions

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Objectives In Structured Products

• Primary Objective(s) of Using Hybrids Is…?

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Objectives In Structured Products

• Primary Objectives of Using Hybrids Are Typically To… – Lower Hedging Costs– To More Precisely Match A Hedge To

Underlying Exposure(s)– Other?

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Cross-Market Hedge Instruments

• What Are The Typical Major Market Exposures (In Terms Of Price Risks) For Most Companies?

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Cross-Market Hedge Instrument

• What Are The Typical Major Market Price Exposures For Most Companies?– Commodities– Currencies– Interest Rates– Other?

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Hedge Alternatives

• How Can These Major Market Price Exposures Be Hedged?– Individually– Jointly– Fully– Partially– Not At All

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Attractiveness Of Alternatives

• What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks?– Aside From Possibly Being Seen As Clever Or

Innovative

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Attractiveness Of Alternatives

• What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks?– May Depend Largely On the Correlation Of

Past, Expected And Actual Future Price Moves– And The Joint Hedge Structure Crafted– And Corporate Objectives (Financial Results,

Cash Flow Requirements, …)

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Typical Structure – Total Cost Cap

• A Derivative Products Dealer Guarantees To An Airline That…– The Total Cost That The Airline Will Incur For

Interest Expense and Jet Fuel Purchases Will Not Exceed Some Specified Total Dollar Amount

– For A Given Quantity Of Jet Fuel Consumption And A Set Amount Of Floating Rate Funding

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• The Airline Could Of Course Buy Caps On Jet Fuel Costs and Interest Rates, Separately

• What Is the Potential Attraction Of The Total Cost Cap Described?

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• What Is the Potential Attraction Of The Total Cost Cap Described?– Lower Aggregate Premium Costs– Simplicity (For The Buyer, Not The Seller)– Other? Possibly Counter Party Credit Risk

• Disadvantages?– Illiquidity In Secondary Trading

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• Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure?

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• Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure?– Lower Valuation On The Instrument– Due To Lower Probability Of The Hybrid

Option Being In The Money

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• How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions?– Well It Depends…

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• How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions?– It Depends On…– Correlation Of Prices– Structure Of The Hybrid Cap; Ratio Of

Quantities, Seasonal Time Period, Jet Fuel Illiquidity And Hence Quantity Hedged

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• Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element?

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• Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element?– Depends On What They View Themselves As

Hedging – All Unfavorable Rate Movements– Costs– Cash Flows

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• Is The Correlation Of Price Moves Between Energy And Interest Rates High?

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• Is The Correlation Of Price Moves Between Energy And Interest Rates High?– Intuitively One Might Think So– But In Fact For Most Time Periods Historically

The Correlation Levels Have Been Rather Low

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Another Example – Knock Out I-Rate Caps

• Popular With Independent Gas Producers

• A Hybrid, Cross-Market, Structured Product That Focuses On Reducing Interest Rate Hedge Costs By Eliminating Coverage When Cash Flows From Natural Gas Revenues Are Known To Be High

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Another Example – Knock Out I-Rate Caps

• Standard Interest Rate Option (Rate Cap), That Is “Knocked Out” If Gas Prices Rise Above Some Pre-defined Level

• Interest Rate Cap Premium Is Below Market, But The Holder Loses Coverage If Gas Prices Jump Up– But The Gas Producer May Not Be Concerned

About Financing Costs Since They Will Be Generating So Much Revenue On Gas Sales

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Other Hybrids

• Structured Notes

• Commodity Indexed Bonds

• Semi-Fixed Or Digital Swaps

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Conclusions

• Structured Products Serve An Important Market Function– Although A Few Are Fluff Or Trickery

• Can Be Somewhat Complex To Price And Trade

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structured products hybrids

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typical major market

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hedge alternativeshow

separate hedge transactions

terms of price risks

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