Goldman Nikkei Case

In: Business and Management

Submitted By pfbuffet
Words 1719
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Question 1
What was the motivation to issue Nikkei-linked Eurobonds?
The motivation for the European bank issuers of the Eurobonds, wasthe possibility to get U.S. dollar finance for a lower interest rate. Toachieve 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 swapcounterparty for hedging the exposure to the Yen-Dollar exchangerate 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 rateto 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 lessthan 7%. The amount by which the 7% exceeded the normal couponrate can be seen as the put premium paid by the issuer. If, atmaturity, the Nikkei dropped below a pre-determined value (hencethe theoretical strike price of the put) the bond’s final payment tothe investor decreased. Hence the issuer would make a profit if theNikkei dropped below the ‘strike price’. The resulting profit schemeexactly represents a normal long put option on the Nikkei.
How could you dynamically replicate these puts by the Nikkei stocksand risk free assets?
To
dynamically replicate the put option we short all the…...

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Karl Johnson | Saikyou no Futari | Chap 566