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Structured Products Hybrids

Return to Risk Limited website: www.RiskLimited.com. Structured Products Hybrids. October 2004. Structured Products & Hybrids. Linked Instruments Cross-Market Transactions. Objectives In Structured Products. Primary Objective(s) of Using Hybrids Is…?. Objectives In Structured Products.

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Structured Products Hybrids

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  1. Return to Risk Limited website: www.RiskLimited.com Structured ProductsHybrids October 2004

  2. Structured Products & Hybrids • Linked Instruments • Cross-Market Transactions

  3. Objectives In Structured Products • Primary Objective(s) of Using Hybrids Is…?

  4. Objectives In Structured Products • Primary Objectives of Using Hybrids Are Typically To… • Lower Hedging Costs • To More Precisely Match A Hedge To Underlying Exposure(s) • Other?

  5. Cross-Market Hedge Instruments • What Are The Typical Major Market Exposures (In Terms Of Price Risks) For Most Companies?

  6. Cross-Market Hedge Instrument • What Are The Typical Major Market Price Exposures For Most Companies? • Commodities • Currencies • Interest Rates • Other?

  7. Hedge Alternatives • How Can These Major Market Price Exposures Be Hedged? • Individually • Jointly • Fully • Partially • Not At All

  8. Attractiveness Of Alternatives • What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks? • Aside From Possibly Being Seen As Clever Or Innovative

  9. Attractiveness Of Alternatives • What Would The Main Advantage(s) Be Of Jointly Hedging The Company’s Major Market Price Risks? • May Depend Largely On the Correlation Of Past, Expected And Actual Future Price Moves • And The Joint Hedge Structure Crafted • And Corporate Objectives (Financial Results, Cash Flow Requirements, …)

  10. Typical Structure – Total Cost Cap • A Derivative Products Dealer Guarantees To An Airline That… • The Total Cost That The Airline Will Incur For Interest Expense and Jet Fuel Purchases Will Not Exceed Some Specified Total Dollar Amount • For A Given Quantity Of Jet Fuel Consumption And A Set Amount Of Floating Rate Funding

  11. Typical Structure – Total Cost Cap • The Airline Could Of Course Buy Caps On Jet Fuel Costs and Interest Rates, Separately • What Is the Potential Attraction Of The Total Cost Cap Described?

  12. Typical Structure – Total Cost Cap • What Is the Potential Attraction Of The Total Cost Cap Described? • Lower Aggregate Premium Costs • Simplicity (For The Buyer, Not The Seller) • Other? Possibly Counter Party Credit Risk • Disadvantages? • Illiquidity In Secondary Trading

  13. Typical Structure – Total Cost Cap • Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure?

  14. Typical Structure – Total Cost Cap • Why Would The Derivatives Dealer Charge A Lower Premium On The Cap For The Combined Exposure? • Lower Valuation On The Instrument • Due To Lower Probability Of The Hybrid Option Being In The Money

  15. Typical Structure – Total Cost Cap • How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions? • Well It Depends…

  16. Typical Structure – Total Cost Cap • How Much Cheaper Is The Total Cost Cap Than The Aggregate Premium On The Separate Hedge Transactions? • It Depends On… • Correlation Of Prices • Structure Of The Hybrid Cap; Ratio Of Quantities, Seasonal Time Period, Jet Fuel Illiquidity And Hence Quantity Hedged

  17. Typical Structure – Total Cost Cap • Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element?

  18. Typical Structure – Total Cost Cap • Is The Airline Fully Hedged By Using This Hybrid? Or Is There A Speculative Element? • Depends On What They View Themselves As Hedging • All Unfavorable Rate Movements • Costs • Cash Flows

  19. Typical Structure – Total Cost Cap • Is The Correlation Of Price Moves Between Energy And Interest Rates High?

  20. Typical Structure – Total Cost Cap • Is The Correlation Of Price Moves Between Energy And Interest Rates High? • Intuitively One Might Think So • But In Fact For Most Time Periods Historically The Correlation Levels Have Been Rather Low

  21. Another Example – Knock Out I-Rate Caps • Popular With Independent Gas Producers • A Hybrid, Cross-Market, Structured Product That Focuses On Reducing Interest Rate Hedge Costs By Eliminating Coverage When Cash Flows From Natural Gas Revenues Are Known To Be High

  22. Another Example – Knock Out I-Rate Caps • Standard Interest Rate Option (Rate Cap), That Is “Knocked Out” If Gas Prices Rise Above Some Pre-defined Level • Interest Rate Cap Premium Is Below Market, But The Holder Loses Coverage If Gas Prices Jump Up • But The Gas Producer May Not Be Concerned About Financing Costs Since They Will Be Generating So Much Revenue On Gas Sales

  23. Other Hybrids • Structured Notes • Commodity Indexed Bonds • Semi-Fixed Or Digital Swaps

  24. Conclusions • Structured Products Serve An Important Market Function • Although A Few Are Fluff Or Trickery • Can Be Somewhat Complex To Price And Trade

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