Abenaa Ampratwum Cases in Derivatives Case Write-up Week 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 lot of 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!

$. %&plain how a convertible bond "works.# Why might a firm want to issue convertible bonds? Why would someone want to convert the bond? What is relin'uished upon conversion and what is received?
Convertible debentures allow debenture holders the right to convert their bonds into the common stock of the issuer corporation! -ow a debenture is converted into a stock depends on certain conversion features! Conversion features consist of a conversion price$ which is established at the point of issuance and determines the number of shares of common stock a

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 wa s! .irst and foremost$ convertible bonds tend to have lower interest rates than non-convertibles because the also accrue value as the price of the underl ing 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 sidewa s$ 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 or why 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 h brid 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

appreciates! Convertibles normall behave as follows& When the underl ing 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 relative value 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! 6tock 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 (6 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 !

1. 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 6traight bonds in the Eurodollar market because the are hedged in that market!