Derivatives Case Goldman, Sachs & Co.

Nikkei Put Warrants-1989 Yannick Ausma Anoer Ilahi 5976081 5780063 Sander Klemann 5732689 Anne Mei Poppe 5733189

Question 1 What was the motivation to issue Nikkei-linked Eurobonds? The motivation for the European bank issuers of the Eurobonds, was the possibility to get U.S. dollar finance for a lower interest rate. To achieve this, the issuer could sell the embedded put to Goldman Sachs. The profits from the put offset the difference between the 7% coupon they paid on the bonds and the desired LIBOR floating rate. The payment from the put covered the cost paid to the swap counterparty for hedging the exposure to the Yen-Dollar exchange rate and swapping the LIBOR for a higher coupon rate. The European financial institution was left with a fully hedged U.S. dollar financing with a lower than normal coupon rate. Furthermore, due to some specific administrative regulation in Japan, the demand for these kind of coupons was high. In Japan, companies where not allowed to pay dividend out of capital gains. Moreover, dividend payments where an important factor in gaining an competitive advantage. Therefore, this bond construction allowed the Japanese life insurers (investors) to use the coupon rate to pay out dividend while still maintaining an exposure to the Nikkei. How are the puts embedded in the Nikkei-linked Eurobonds?

A normal bond to Japanese institutions would pay a coupon rate less than 7%. The amount by which the 7% exceeded the normal coupon rate can be seen as the put premium paid by the issuer. If, at maturity, the Nikkei dropped below a pre-determined value (hence the theoretical strike price of the put) the bonds final payment to the investor decreased. Hence the issuer would make a profit if the Nikkei dropped below the strike price. The resulting profit scheme exactly represents a normal long put option on the Nikkei. How could you dynamically replicate these puts by the Nikkei stocks and risk free assets? To dynamically replicate the put option we short all the stocks represented by the Nikkei and lend the proceeds from this transaction against the risk free rate, or, in other words invest in risk-free assets. The amount of shares that we should short would be equal to , which can be calculated using the Black-Scholes-Merton model:

Where

This will always be negative for a put, which implies a short position and lending the proceeds (as stated before). Also notice the minus 1 in the first equation to see why the will be negative for a replicating put. Would this be practically feasible?

Since this replication consists of shorting a position on all 225 stocks of the Nikkei, this is not practically feasible.

Question 2 What features are primarily client focused, and what aspects are focused at simplifying the hedge? American- vs. European-style option: U.S. investors were more comfortable with American-style options, also it is more valuable for the holders of an option to have the opportunity to exercise earlier, so the decision to maintain an American style option was client focused. Length of contract (expiration date): The length of the contract depends on the available puts from Goldman Sachs' inventory. Since the inventory contained puts up to a maturity of 4 years the warrant 3 years life is chosen to simplify the hedge. Treatment of exchange-rate risk: The choice to use a fixed exchange rate set at the outset of the contract is focused at the client. Clients who want to bet against the Nikkei would not want to take an additional exchange risk. By fixing the exchange rate the investors do not have this exchange rate risk, since the dollar payoff is known with certainty. Treatment of contract rights in case of extraordinary events: We assume that the treatment of extraordinary events in case of the NWP will be similar to the clauses shown in exhibit 4. The contract specifies that in case of extraordinary events a cash settlement

price will be used that depends on the valuation of the first day that there is no such extraordinary event. In case of these events, for example war, performing the obligations might be very difficult or costly. Hence this clearly benefits the issuer and is therefore focused at making the hedge simpler. Warrant size/price: Since the warrant were designed to be sold to individual investors, the size and aligned with size its price, were set such that small investors could actually afford them. Furthermore the price should not have been too low otherwise it could not have been sold on the American Stock Exchange. Hence the warrant size is focused on the client. Question 3 Why is the Kingdom of Denmark issuing these warrants? Goldman Sachs was not able to issue the warrants publicly themselves without making material public disclosures, because they were a private partnership, and a non-SEC registrant. It therefore had to find an issuer for the warrants. The Kingdom of Denmark was chosen for multiple reasons: 1. The Kingdom of Denmark was a non-U.S. issuer, which meant no exposure to adverse reporting implications (U.S. issuers must report the obligation to buy the Nikkei from investors and the put purchased from Goldman Sachs as an increase in leverage, even though this transaction is perfectly hedged, and thus bears no risk). 2. The Kingdom of Denmark was stated highly creditworthy. 3. The Kingdom of Denmark was a sovereign entity with broad name recognition among U.S. retail investors. Question 4

What risks does GS bear in executing this transaction? How are these risks mitigated? A risk that GS bears in issuing the puts, is the risk in holding a large inventory of Nikkei put warrants. If for example the price of NPWs is too high, it could result in unsold NPWs and thus in a high inventory. GS mitigated the risk of holding these NPWs by taking offsetting futures positions in the Nikkei offered by the Singapore, Osaka and Tokyo stock exchanges. A second risk that GS bears is the exchange rate risk: GS buys NPWs in Yen and sells the NPWs to investors in Dollars for a fixed exchange-rate set at the time of the offering. Since the inventory of NPWs is bought in yen, while GS is a U.S. operating bank, it implies that GS bears the risk that the inventory of puts will get less valuable if expressed in dollars when the dollar gets more expensive. So if for example GS wants to sell their inventory in dollars, they would get less for it in dollars. Also the value on the balance sheet in dollar will decrease if the dollar gets more expensive. At the time of the issue in the 80s, the Nikkei index and the yen/dollar exchange rate moved in opposite direction. If the Nikkei would decline in value and the dollar would appreciate, which was the predicted relationship at that time, GS would have to deliver more dollars and thus would make losses. This risk could be mitigated by Quantos. GS estimated that fully hedging against the exchange rate risk, cost about $1 per warrant and around $ 0.50 per warrant when 80% of the exchange rate risk is hedged.

Another risk is setting the right price for the NPWs; not too expensive and not too cheap. The risk related to pricing the NPWs too high is that there is no or low demand for that price, and GS would be left with an unsold inventory. Next to that, competitors could replicate the product and offer it for a lower price in the market. In contrast, if the price is too low, GS will not acquire their desired profit margin or in the worst case book losses on their sales.

Question 5 Assuming that GS can hedge its currency risk using Quantos for $1 per warrant, what would be the lowest price per warrant that GS can charge for the currency hedged NPWs and still break-even? What if the NPWs were European style? What if they were American style: do you expect much difference? In order to find the break-even price of the NPWs for Goldman Sachs, we first calculate the intrinsic value of an option, which is together with the currency hedge the variable cost per NPW. The value of the NPW is calculated for if it were an European and American style option. However, we will base our break-even price calculations on the American style, since this is how the NPW is actually offered. Next, we calculate the fixed costs of bringing the NPW to the market, thereafter we present the calculations of the break-even selling price. Assumptions:

Volatility is constant Securities are traded continuously

No fees and transactions costs The risk free rate is constant and it is possible to borrow and lend at this rate The index follows a Brownian motion with constant drift

Data input for calculation for calculations intrinsic value:

issue date = 19-12-1989 S0 = Nikkei index = 38586.16 Exchange rate /$ = 144.28 Exercise price = 38587.68 implied volatility = = 13.6% q = dividend yield = 0.49% rf = risk-free rate = 5.85%1 T = time to maturity = 3 years

By plugging this data into DerivaGem we find a value for an European style NPW of 1211.63 which is converted to dollars $1.68 ( 1211.63/5*144.28). For the American style put option we found a value of 1852.7933 or $2.57. We indeed expected that American puts have a substantial higher value, because the expiration date is quite long. Adding the $ 2.57 to the $1 cost of hedging the currency risk by Quantos, we find a total variable cost of $3.57 Summation of fixed costs

1 2

Fee for the Kingdom of Denmark Legal and listing fees Commissions Costs of R&D time and effort Total fixed costs

$ 1.300.000 $ 350.000 $ 3.000.000 $ 1.250.0002

$ 5.900.000

The Japanese bonds with a 3-year maturity are used, since the maturity of the option is also 3 years. We estimated the salary of a single specialist to be $125.000, multiplied by 10 person years of work = $1.250.000

Knowing that Goldman Sachs expects to offer 9.500.000 NPWs, the fixed costs per NPW are: $ 5.900.000/ 9.500.000 = $ 0.621. Adding the fixed costs per contracts to the variable costs, we find a break-even selling price of $4.191. Now Goldman Sachs must find a profit margin which balances the downside of a high margin and the upside of a low margin. On a side note, we can conclude that Goldman Sachs minimum price of $5,- (so the NPW could be used for short selling) is too high. This is shown above, because the intrinsic value of the NPW is below $5,-, which means third party issuers could offer the same product for a lower price.