Merril Lynch (Capital Structure Arbitrage) 2003-12-15


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An introduction to capital structure arbitrage

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Merril Lynch (Capital Structure Arbitrage) 2003-12-15

  1. 1. Credit & Equity-Linked Strategy Capital Structure ‘Arbitrage’ A Tradable Dollars and Cents Approach An Introduction December 2003 Please refer to important disclosures on page 12 and Analyst Certification on page 11.
  2. 2. 2 A Tradable Relative Value Approach Credit and equity risk are unambiguously linked as the risk of debt holders not receiving their claims is the risk of equity prices falling to zero. Both credit and equity risk are directly tradable with derivatives in the marketplace - credit default swaps and equity puts for instance. The close similarity between credit and equity derivatives has recently led the marketplace to search for any mis-pricing between these two asset classes. At the forefront of understanding the linkages between credit and equity valuations are structural models such as KMV and CreditGrades which are based on Merton, Black and Scholes academic work in the early 70’s on evaluating corporate liabilities. In short, these models use inputs from the equity market to evaluate credit instruments, however they do not seek to identify trade opportunities that capitalize on the potential mis-pricing of credit and equity derivatives instruments. Our approach consists of searching the universe of liquid credit and equity derivatives in order to identify tradable long / short pairs where either the credit or equity risk may be mis-priced. Because credit and equity derivatives markets operate largely independently, this can easily lead to the relative mis-pricing of the traded instruments.
  3. 3. 3 Correlation between Credit and Equity Risk TRACERS CDS vs S&P 500 Option Implied Volatility Daily Data from Apr 23, 02 to Oct 22, 03 CDS Pricing vs Option Implied Volatility As of Oct 22, 03 The cost of ‘Credit Protection’ (measured by the pricing of Credit Default Swaps) correlates with the cost of ‘Equity Protection’ (measured by equity option implied volatilities), on the aggregate over time (left chart) as well as cross-sectionally at one point in time (right chart). Neither relation is perfect, however, and credit and equity risk may be mis-priced relative to each other. WMT DELL WFC GS HPQ WM VZ CCU AEP DCX TYC L TXU HOT NXTL DISH GM EDS MO MBG F RCL GP BOW THC PVN RJR R2 = 46% 15% 25% 35% 45% 0 50 100 150 200 250 300 350 400 450 500 3-Year CDS 50DeltaJan06EquityOptionImpliedVolatility 0 50 100 150 200 250 300 350 Apr 02 Jun 02 Aug 02 Oct 02 Dec 02 Feb 03 Apr 03 Jun 03 Aug 03 Oct 03 5-YearCDSPremiumperannum(bp) 10% 15% 20% 25% 30% 35% 1-YearS&P500ImpliedVolatility TRACERS CDS S&P 500 Implied Volatility R2 = 85%
  4. 4. 4 Short CDS vs Long Equity Put: Trade Mechanics Searching for cases where the premia of a short CDS position exceed the cost of an equity put credit hedge. Calculate the present value of CDS premia over the duration of the put option contract; the present value approach is used to address any potential timing mismatches between the CDSs, which most commonly trade with 5 year maturity, and the listed equity puts, where the longest available expiration is currently Jan 06. Determine the potential CDS liability, i.e. ( 1 - Recovery ) x CDS Notional. Make an assumption what the stock price will be should debt default occur, e.g. $0.75 which was the average price for former S&P 500 companies at the time of default. Determine the number of puts necessary to hedge the estimated credit risk, i.e. CDS Liability / ( Put Strike - Assumed Stock Price if Default). Determine the cost of the equity put credit hedge, i.e. Number of Puts x Put Ask Price. Two decision variables: Given a recovery assumption, does the present value of CDS premia over the life of the Jan 06 option pay for the put hedge? What recovery value equates the cost of the put hedge to the present value of CDS premia over the duration of the put option?
  5. 5. 5 Short CDS vs Long Equity Put: Screening for Opportunities Example Calculations Open Interest as an Option Liquidity Measure: 91,082 contracts are outstanding, i.e. credit protection worth $84,250,850 = 91,082 * 100 * ($10.00 - $0.75) = Open Interest x Multiplier x (Strike Price - Default Stock Price Assumption). Cost of Put Hedge: $7.46 = (1 - Assumed Recovery) *100 / (Strike Price - Assumed Stock Price if Default) * Put Ask Price = ( 1 - 40% ) * 100 / ( $10 - $0.75 ) * $1.15. Present Value of CDS Premia: The value of CDS premia over the duration of the put contract discounted by the libor rate and adjusted for the probability that the CDS premia will not be received should default occur. Decision Variable 1: PV of the CDS premia exceeds the cost of the put Hedge by $1.50 (assuming 40% recovery). Decision Variable 2: PV of the CDS premia equals the cost of a put hedge if recovery equals 27%. assumed bid premium pv ask open strike stock stock price price assumed through cost of pv cds break-even ticker name price interest price price if default (bp) recovery Jan 06 put hedge - put hedge recovery EIX Edison International 1.10 9,000 15.0 19.82 0.75 474 40% 9.61 4.63 4.98 -- GM General Motors 0.50 7,934 10.0 41.88 0.75 191 40% 4.07 3.24 0.83 24% RJR RJ Reynolds 1.15 91,082 10.0 42.42 0.75 439 40% 8.96 7.46 1.50 27% MO Altria Group 0.90 1,732 15.0 45.30 0.75 212 40% 4.51 3.79 0.73 28% GP Georgia-Pacific 0.80 1,022 10.0 25.84 0.75 281 40% 5.89 5.19 0.70 31% BOW Bowater 1.75 24,480 20.0 41.75 0.75 288 40% 6.04 5.45 0.58 33% Selected Cases as of Oct 22, 03. by recovery assumption Description Jan 06 Equity Put Hedge 3-Year CDS Put vs CDS
  6. 6. 6 Short CDS vs Long Equity Put: The Opportunity Set CDS Premia through Jan 06 vs Equity Put Hedge Cost Assuming 40% Recovery; Selected Cases as of Oct 22, 03 Break-Even Recovery Values Selected Cases as of Oct 22, 03 Assuming 40% recovery, Edison International (EIX), General Motors (GM), RJ Reynolds (RJR), and Altria (MO), and are among the cases where the expected present value of CDS premia through Jan 06 exceeds the cost of an equity put hedge. For Edison International (EIX), the break-even recovery is ‘negative’ as the present value of CDS premia over the duration of the option contract exceeds the cost of the equity put hedge even under the zero recovery scenario. EDS RCL F FE JCP NAV HCA TYC DISH SPOT BOW GP MO RJR GM EIX 2 4 6 8 10 2 4 6 8 10 Present Value of CDS Premiums over Duration of Jan 06 Put Hedge ($) CostOfJan06PutHedge($) 0% 24% 27% 28% 31% 33% 35% 43% 44% 45% 46% 56% 56% 57% 58% 59% 0% 20% 40% 60% EIX GM RJR MO GP BOW SPOT DISH TYC HCA NAV JCP FE F RCL EDS BreakEvenRecovery
  7. 7. 7 Short CDS vs Long Put: Advantages & Risks Trade Opportunities The Put Option is an ‘Over-Hedge’ The stock price can fall below the put strike without the occurrence of a credit event that triggers a CDS liability. Thus the holder of the short CDS / long put position could potentially obtain a put pay-off without being liable to pay out on the CDS. Trade Risks The most frequently traded CDSs have a 5 year maturity while the currently available longest dated listed put options expire Jan 05 or Jan 06. Any timing difference between 5- year CDSs and shorter dated puts leave investors at maturity of the puts with non- expired CDS positions. This creates the risk that the value of credit protection may rise by maturity of the put while the put option is out-of-the-money. Solutions Shorter dated CDSs can also be available, although CDS contracts with 5-year maturity are most commonly traded. Longer dated equity puts may be available in the over-the counter options market. At expiry (or over the duration) of the put contract, the short CDS position may be re-hedged with puts of later expiry. The trade may be unwound profitably before the put expiry.
  8. 8. 8 Short CDS vs Long Put: Advantages & Risks Trade Risks (Continued) The stock price might not fall to (or below) $0.75 as assumed in the event that the short CDS position triggers a liability. Solutions A higher, more conservative stock price may be set when calculating the number of puts used to hedge the credit risk. Equity put hedges based on options with higher strike prices are less sensitive to the assumed ‘default’ stock price. The Present Value of CDS premia through option expiration is an expected value, but not necessarily a realized outcome. Solutions The present value calculations can be improved by studying the arrival of corporate liabilities (on Bloomberg via the DDIS function, for instance). Although this should improve the accuracy of the present value estimate, it is nonetheless subject to error. In the even of credit default, it may take a long time to ‘recovery’ any claims on the company’s assets and the recovery value may be lower than expected.
  9. 9. 9 Alternative Capital Structure Models Short CDS vs Long Equity Variance Swap An alternative to the short CDS / long put model to take advantage of ‘cheap’ equity risk. A long Variance Swap position generates cash in-flow (out-flow) should volatility increase above (decrease below) the set volatility strike. Should debt default occur, the stock’s realized equity volatility should increase and thus the long Variance Swap position can offset the CDS liability. Should no default occur, one bears the risk that the realized volatility falls below the Variance Swap strike. Such liability can however be offset by the cash-flow generated from the CDS premia. Buy-Write (Long Stock & Short Equity Call) vs Long CDS Taking advantage of ‘expensive’ equity risk. A buy-write consists of the simultaneous purchase of a stock and the sale of an out-of-the- money call option. The call premium may be used to finance multiple CDSs to protect the downside of the buy- write. The combined position allows for stock appreciation to the strike price of the call, while the downside can be protected with the long CDS position.
  10. 10. 10 Other Capital Structure Models Synthetic Convertible Bonds Obtaining ‘cheap’ equity exposure with ‘expensive’ credit risk. A convertible bond is essentially (a) short a CDS, (b) long a risk-free asset, and (c) long a call option and thus may be created synthetically. Though the correlation of credit risk and equity risk is significant (see page 3), for a given level of credit risk, the cost of equity risk can vary substantially, i.e. one can identify candidates where for similar downside risk (e.g debt default) one obtains the most upside via calls. Equity Put Ratio Spreads Taking advantage of steep equity put skew. The demand for credit protection via low strike puts has steepened the strike skew for many equities, i.e. lower strike options have significantly higher implied volatilities than that higher strike options. Equity put ratio spreads can take advantage of a steep strike skew by selling multiple far out-of-the-money put options for every near the money put option one is long (for instance, a 6 x 1 ratio spread could consist of selling six $5 strike puts while buying one $30-strike put). Though a ratio spread requires a premium, the cost of the position is substantially reduced when the strike skew is steep. The option pay-off cannot be negative and reaches its maximum at the low strike put. Thus, holders of ratio spreads take the view that the stock price will fall, but not collapse below the low strike put.
  11. 11. 11 Contact Information Credit & Equity-Linked Strategy Michael Maras +44 20-7996-2510 Benjamin Bowler +1 212-449-3199 Yaw Debrah +1 212-449-0174 Heiko Ebens +1 212-449-1049 Equity Derivatives Sales Mickey Strasser +1 212-449-3313 Credit Derivatives Sales Doug Mallach +1 212-449-6190 Analyst Certification I, Heiko Ebens, hereby certify that the views expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in this research report.
  12. 12. 12 Important Disclosures MLPF&S or one or more of its affiliates acts as a market maker for the recommended securities to the extent that MLPF&S or such affiliate is willing to buy and sell such securities for its own account on a regular and continuous basis: Genl Motors; Edison Intl; R.J. Reynolds; Altria Group. MLPF&S or an affiliate was a manager of a public offering of securities of this company within the last 12 months: Genl Motors. An officer, director or employee of MLPF&S or one of its affiliates is an officer or director of this company: Genl Motors. MLPF&S or an affiliate has received compensation for investment banking services from this company within the past 12 months: Genl Motors; Altria Group. MLPF&S or an affiliate expects to receive or intends to seek compensation for investment banking services from this company within the next three months: Genl Motors; Edison Intl; R.J. Reynolds. MLPF&S together with its affiliates beneficially owns one percent or more of the common stock of this company calculated in accordance with Section 13(d) of the Securities Exchange Act of 1934: Genl Motors; Edison Intl; R.J. Reynolds; Altria Group. Additional information pursuant to Section 34b of the German Securities Trading Act: Merrill Lynch and/or its affiliates was an underwriter in an offering of securities of the issuer in the last five years: Genl Motors; Edison Intl; R.J. Reynolds. The analyst(s) responsible for covering the securities in this report receive compensation based upon, among other factors, the overall profitability of Merrill Lynch, including profits derived from investment banking revenues. Futures and options are not appropriate for all investors. Such securities may expire worthless. Before investing in futures or options, clients must receive the appropriate risk disclosure documents. Investment strategies explained in this report may not be appropriate at all times. Costs of such strategies do not include commission or margin expenses. In Germany, this report should be read as though Merrill Lynch has acted as a member of a consortium which has underwritten the most recent offering of securities during the last five years for companies covered in this report and holds 1% or more of the share capital of such companies. OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potential price fluctuation, are: A - Low; B - Medium; and C - High. INVESTMENT RATINGS, indicators of expected total return (price appreciation plus yield) within the 12-month period from the date of the initial rating, are: 1 - Buy (10% or more for Low and Medium Volatility Risk Securities - 20% or more for High Volatility Risk securities); 2 - Neutral (0-10% for Low and Medium Volatility Risk securities - 0-20% for High Volatility Risk securities); 3 - Sell (negative return); and 6 - No Rating. INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure); 8 - same/lower (dividend not considered to be secure); and 9 - pays no cash dividend. Copyright 2003 Merrill Lynch, Pierce, Fenner & Smith Incorporated (MLPF&S). All rights reserved. Any unauthorized use or disclosure is prohibited. This report has been prepared and issued by MLPF&S and/or one of its affiliates and has been approved for publication in the United Kingdom by Merrill Lynch, Pierce, Fenner & Smith Limited, which is regulated by the FSA; has been considered and distributed in Australia by Merrill Lynch Equities (Australia) Limited (ACN 006 276 795), a licensed securities dealer under the Australian Corporations Law; is distributed in Hong Kong by Merrill Lynch (Asia Pacific) Ltd, which is regulated by the Hong Kong SFC; and is distributed in Singapore by Merrill Lynch International Bank Ltd (Merchant Bank) and Merrill Lynch (Singapore) Pte Ltd, which are regulated by the Monetary Authority of Singapore. The information herein was obtained from various sources; we do not guarantee its accuracy or completeness. Additional information available. This research report is prepared for general circulation and is circulated for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investors should note that income from such securities, if any, may fluctuate and that each security's price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not necessarily a guide to future performance. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures or other derivatives related to such securities ("related investments"). MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner, specialist and/or arbitrageur in any securities of this issuer(s) or in related investments, and may be on the opposite side of public orders. MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities of this issuer(s) or in related investments. MLPF&S or its affiliates may from time to time perform investment banking or other services for, or solicit investment banking or other business from, any entity mentioned in this report. Foreign currency rates of exchange may adversely affect the value, price or income of any security or related investment mentioned in this report. In addition, investors in securities such as ADRs, whose values are influenced by the currency of the underlying security, effectively assume currency risk.