1、Topic 18, Exercise 2Synthetic DebtThe investment banking firms and major corporations have worked together to use derivatives to implement financing strategies that reduce costs and or risks associated with traditional instruments. This activity is generally known as structured finance or financial
2、engineering. It involves the combination of traditional instruments and derivative instruments such as options. One such instrument, called putable/callable reset bonds or term enhanced marketable securities, is described in a recent article entitled, “Can Synthetic Debt Give Authentic Savings?” Aft
3、er reading the article, answer the following questions:1. What are putable/callable reset bonds?Putable/callable reset bonds have both an embedded put and call. The normal instrument has a nominal maturity of 10 years but has a mandatory put provision requiring the issuer to put the bond back on the
4、 issuer if interest rates have risen since the time of issue. The call feature allows the investment banker to call the issue if rates have fallen from the time of issue. The call option has a value at the time it is created and the issuer receives the premium or the value of the option at the time
5、the bond is sold.2. What potential advantage does the corporation receive for offering this type of security?Since the issuer is entitled to the option value paid by the investment banker when the security is first sold, the premium reduces the borrowing cost if interest rates increase. The option t
6、o call the bond will not be valuable if interest rates rise following the initial issuance. So, the initial affect is a lower cost to the issuer.3. What is the offsetting feature or downside risk associated with this type of security?There are potential and significant back door costs if interest ra
7、tes decline. When rates decline, the call provision will be valuable and the issuer will have to pay the investment banker the value of the option. This will effectively increase the interest cost to the firm when compared to the rate the corporation could have paid if it hadnt written the option and received the initial premium. If rates increase, the mandatory put comes into play and the issuing corporation will have to pay an additionally higher rate on the new funding. It will have saved some interest expense in the earlier period.
