THE PRACTICAL APPLICATION OF EQUITY DERIVATIVES FOR

CORPORATES

The perfect Hedger and the Fox17 April 2013

Dr Antonie Kotzé

Financial Chaos Theory

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

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

What’s in it for corporates?

Derivatives expanded the

universe of

instruments available

for trading and

hedging

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

Black-Scholes through the eyes of.....

Let’s demistify options

Derivatives as simple diagrams

a future has unlimited profit potential, but such a

diagram also shows the potential losses

P/LShort

Future

K K’

Long

Future

Options as simple diagrams

K

Long

Put

Payoff

KShort

Put

Payoff

KShort

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

The Formulas

• Future

• Option

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

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

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 incomeMyron Scholes on the floor

of the CBOE

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.

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.

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.

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?

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!!

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

How?

S

Long

Richemont

Long

put

K= 18.22

Short

call

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

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

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

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

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

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

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

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

Long

preference

shares

K=675p

Long

putSynthetic

call

Short

call

Position:

SQUARE

The structure

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

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?

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.

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.

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

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.

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.

S

Long LTCM

shares

Short

call

Short

synthetic

put

A clever deal?

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

Hedgers and foxes

Equity derivatives can be used

effectively by corporates to

hedge certain contractual

liabilities

Understand the risks involved

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.