on the evening of february 20 2012 private

Question

On the evening of February 20, 2012 private institutional investors, representatives of the IMF, ECB, and European governments agreed to a major "intervention" to solve the sovereign Greek crisis. The objective of this agreement, which follows the first package of measures enacted in May 2010, is to significantly reduce the debt burden of the Greek government preventing an historical default. Such catastrophic financial event could create panic on capital markets and a domino effect spreading to the securities issued by several European governments.

According to the agreement, private investors would accept the following conditions:

• A reduction of 53.5% inthe face value of all current Greek government and government-sponsored fixed-income securities ("Old Greek Bonds").
• The remaining 46.5% of the debt is exchanged for new securities as following:
  • "New Greek Bonds" issued by the Greek government maturingin 2023 and2042 and step-up coupons ranging from 2% to 4.5%. (31.5%)
  • "New EFSF Notes" issued by the European Financial Stability Fund (EFSF) with a fixed coupon of 1.5% and maturities oftwo and three years. (15%)
  • "GDP-linked Warrants" issued by the Greek government attached to each of the "New Greek Bonds". These securities are scheduled to pay 1% of the "modified" face value of the "New Greek Bonds" if the Real GDP Growth rate for Greece exceeds 2.5% per year during the period 2012-2042.

You are given the following additional information regarding the securities involved in the Private Sector Involvement (PSI) agreement:

• The "Old Greek Bonds" include securities belonging to three categories:
  • Securities issued under Greek law (€182 billion in face value). Half of these securities matures in 2022 and have a fixed coupon rate of 2.5%, the other half comprises securities maturing in 2032 with a fixed coupon rate of 3%.
  • Securities issued by the Hellenic Republic under international law (€18 billion in face value) maturing in 2025 with a fixed coupon rate of 2.8%.
  • Securities issued by other Greek entities like the Hellenic Railways and Hellenic Defense System under international law (€3 billion in face value) maturing in 2022 with a fixed coupon rate of 2.2%.

• The "New Greek Bonds" received in the debt exchange will have a total face value equivalent to 31.5% of the face value of the "Old Greek Bonds":
  • Half of the "New Greek Bonds" matures in 2023 and the other half matures in 2042.
  • The step-up coupon rates of the "New Greek Bonds" are as following: 2% per annum for payment dates between July 2012 and February 2018; 3% per annum for payment dates between July 2018 and February 2023; 4.5% per annum for payment dates in July 2023 and thereafter.

• The "New EFSF Notes" received in the debt exchange will have a total face value equivalent to 15% of the face value of the "Old Greek Bonds":
  • Half of the "New EFSF Notes" matures in 2014 and the other half matures in 2015. Both securities have fixed coupon rates of 1.5%.
  • The European Financial Stability Facility (EFSF) was created by the euro area Member States following the decisions taken on 9 May 2010 within the framework of the ECOFIN Council. The EFSF's mandate is to safeguard financial stability in Europe by providing financial assistance to euro area Member States. To fulfill its mission, the EFSF issues bonds or other debt instruments on the capital markets. The EFSF is backed by guarantee commitments from the euro area Member States.

• The "GDP-linked Warrants" received in the debt exchange would be "attached" to each of the "New Greek Bonds" and therefore would have a face value equivalent to 31.5% of the face value of the "Old Greek Bonds".
  • The "GDP-linked Warrants" are derivatives securities that pay income ONLY if the Greek economy grows at rates above the 2.5% benchmark for the period 2012-2042. The income would be equal to 1% (APR) of the "modified" face value of the "New Greek Bonds". The "GDP-linked Warrants" would not reimburse any principal; they would just pay income on a semiannual basis.
  • The "modified" face value of the "GDP-linked Warrants" is equivalent to the face value of the "New Greek Bonds" until 2024 but it is reduced by 2.5% each semiannual period thereafter until the maturity in 2042.
  • The "GDP-linked Warrants" can be detached from the "New Greek Bonds" and can separately trade in the financial markets.

It is Sunday, February 26 and you are an associate in the fixed-income desk of a major investment bank and your boss just asked you assess the Greek debt exchange. Your objective as an analyst is to value the yield-to-maturity, expected returns and prices of the securities related to the Greek PSI. You are given the following information about the yield-to-maturity on short-term fixed-income securities issued by several governments as of Friday, February 24:

COUNTRY	YIELD-TO-MATURITY
Australia	3.63%
Austria	0.78%
Belgium	1.29%
Canada	1.20%
Denmark	0.31%
Finland	0.40%
France	0.70%
Germany	0.20%
Ireland	5.29%
Italy	2.19%
Japan	0.12%
Netherlands	0.39%
New Zealand	3.13%
Norway	1.75%
Portugal	12.84%
Spain	2.42%
Sweden	1.20%
UK	0.47%
US	0.35%

All the coupon rates stated in the assignment are APRs with semiannual coupon payments. (Keep it simple: assume that all the securities accrue interest starting on February 27, 2012 and pay income at the end of each semiannual period. Hence, on the maturity year the principal is reimbursed on February 27.)

1. The overall package of "Old Greek Bonds" currently trade in financial markets at 12.5% of its total face value. Compute the yield-to-maturity for this portfolio of securities.

2. Markets believe that there is an annual constant probability of 75% that the Greek government will default during the period 2012-2032. In case of a default, markets expect a complete loss in income and capital. Compute the expected rate of return embedded in the current price of the "Old Greek Bonds".

3. You are trying to predict the value of the "New Greek Bonds" and you believe that their yield-to-maturity will be 400 basis points above the yield offered by the securities of another "weak" European government like Portugal. Estimate the value of the "New Greek Bonds". In order to answer this question you can assume a flat yield curve.

4. Value the price of the "New EFSF Notes" and explain the logic you used in selecting an appropriate yield-to-maturity.

5. List the cash flows paid by the "GDP-linked Warrants" under the best scenario.

6. Price the "GDP-linked Warrants" as if the risk of the cash flows were similar to the risk of the "New Greek Bonds". In order to answer this question you can assume a flat yield curve.

7. Compute the overall value of the securities received through the PSI as a percentage of the face value of the "Old Greek Bonds". Would you participate in the Greek debt exchange agreement?

8. Answer question 6) assuming you are certain that the "GDP-linked Warrants" will pay the maximum stated income each period.