Goldman, Sachs & Co. Nikkei Put Warrants †1989

Course OFD Instructor B. Hariprasad Assignment 1 Goldman, Sachs & Co. Nikkei Put Warrants 1989 slit A Ankit Pandey Himanshu Agarwal Suchit Singh Problem Statement What should be the right pricing st locategy for Nikkei Put Warrants (NPWs)? Structure of Nikkei-Linked Euro-Yen legal proceeding 1. The European bank change a bond that promised to make annual interest payments in fade at a fixed interest rate. However, through a set of swaps, the issuer transformed its annual fixed-rate waste payments into dollar-denominated LIBOR-bases payments.This is represented by the left side transaction of the above figure. 2. At maturity, the issuer would redeem the bonds from the investor at a price tied to the Nikkei. If the Nikkei fell since the bonds were issued, the issuer would pay less than par to redeem the bonds. Thus, it would be as if the issuer sold bonds with the final principal payments at par but also bought a put option on the Nikkei maturing in the same year as the bond. If the Nikkei fell, the put would rise in value benefiting the issuer.This reflects the embedded record of the put option. 3. The issuer had no interest in holding this put. It often resold the embedded put options to financial intermediaries comparable Goldman Sachs by promising to deliver, at maturity, the difference between the bonds par value and its Nikkei-linked salvation price. In exchange for promising to make this payment, which equaled the intrinsic value of the embedded put, the bond issuer would be paying(a) an up-front put premium. This is represented by the right side transaction in the above figure. 4.Goldman Sachs then could wander these puts to institutional customers. Not all of these puts were sold to institutional customers. As of December 1989, Goldman Sachs had a significant broth of European-style puts on Nikkei and it was offsetting the attempt on these puts through the futures offered by Singapore, capital of Japan and Osaka stock exchanges. 5. The sales force of Goldman Sachs gave an highly positive feedback on the embedded put options and it was decided that exchange traded put warrants would be a keen product offering from companys point of view.Role of Kingdom of Denmark 1. Goldman Sachs was a private partnership and non-SEC registrant and indeed could not issue the warrants publicly without making material public disclosures. Therefore it was necessary for it to work with an issuer registered with the SEC. The issuer would transport the warrants to the public but simultaneously enter into private contract with Goldman Sachs that exactly offset the obligation beneath the warrant contract. In return, it would receive a fee from Goldman Sachs without effectively having any exposure on Nikkei. . In addition to above argument, the issuer should be highly credit worthy and non US sovereign entity due to unfortunate reporting implications for a US corporate issuer. 3. Based on the above criteria, Goldman Sachs entered into an ag reement with Kingdom of Denmark, which would subscribe to a fee of $1. 3 million from these transactions. ventures exposure for Goldman Sachs 1. Risk of meeting the unsold inventory of NPWs If the investors chance on prices too high then much of the inventory would remain unsold and GS will have to bear the costs of unsold warrants.Risk Mitigation GS would offset its risk through futures position in the Nikkei offered by the Singapore, Osaka & Tokyo stock exchanges 2. Exchange Rate Risks Considering preference of U. S investors, GS would bear the exchange rate risks for its investors. This implies that GS has to sell NPWs in terms of dollars whereas the same has been purchased by it in terms of yen. Also, in the 1980s, the Nikkei and the yen/dollar exchange rate were moving in opposite direction which further increased its exposure to exchange rate risk. Risk MitigationThis can be mitigated through Quantos, a product offered by its currency and commodity division. A complete he dge would cost GS about $1 per warrant whereas hedging 80% of its risk would cost it $0. 50 per warrant only 3. Repute at risk GS would not like to keep the prices really low. At the same time it cannot price them very high as there is a risk that competitors might copy the product and start selling it at demoralise prices. Also, if NPWs started trading at lower prices in the secondary market this would bring disrepute for the organization and its partners involved.Price Calculation Assumptions Constant Volatility Securities are traded continuously Zero transactions costs The risk free rate is constant and it is possible to usurp and lend infinitely at this rate Variables for put intrinsic value calculation S0= Nikkei index = 38586. 16 Exchange rate ? /$ = 144. 28 Exercise price = 38587. 68 Implied Volatility = ? = 13. 6% q = dividend yield = 0. 49% Risk-free rate = 5. 85% T = time to maturity = 3 years Based on the above inputs, the price of American option is 1852. 9 yens which is $2. 57. When cost of hedging is added, this becomes $3. 57. Fixed Costs allowance for Kingdom of Denmark $ 1300000 Legal and listing fee $ 350000 Commissions $ 3000000 Costs of R&D $ 1250000 full(a) $5900000 Cost per NPW $0. 621 Total fixed plus variable $4. 191 Hence, this is the minimum price Goldman Sachs can charge for NPWs. Swap Counterparty European argot (Issuer) Put Warrant Purchaser gr? Y y. /0123