Liquid yield option notes (LYONS) : corporate objectives, valuation and pricing

In 1985, Merrill Lynch introduced Liquid Yield Option Notes, or LYONS into the exotic derivative corporate capital market. Based on a plain vanilla bond, its features were changed to accommodate risk protection for issuers and holders. The hybrid bond is both callable and puttable, it is convertible into common stock, and issued as a zero coupon discount bond. The put and call options are intended to reduce short-term interest rate risk corporations and holders are exposed to. Smith and Smithson (1990) propose that LYONs were introduced to reduce underinvestment, asset substitution, and claim dilution. If LYONs were designed to reduce agency costs and align stockholder/bondholder interests several factors can be associated with these securities according to Nash {1994). Identifying firms likely to issue these securities can be found by examining several financial ratios including, debt to equity, leverage, standard deviation of earnings, and debt rating. It is important to know what type of firm is issuing these securities and if stated objectives align with the empirical evidence embedded in the contractual elements. Few studies have been done in the areas of exotic derivative options but as the amount of capital raised through LYONs approaches $50 billion, it is important for investors to become familiar with this instrument, as many institutional investors for pension funds, and other mutual accounts buy into these instruments. Updating the work of Nash (1994) to include issues of LYONs after 1993 to present will test the indicators defined by his contracting-cost explanation for the existence of LYONs. Further knowledge can be gained by assessing more recent issues. Analyzing how recent interest rate, and federal government regulation of the exotic derivative securities market provides insight into future derived offerings and objectives. This thesis will describe the environment and provide insight into the motivations for bond issuers and holders. My intent is to make an assumption about the outcome versus stated objectives. With a sample set of 20 contracts randomly selected from years 1985-2002, I examine several variables within the contracts and the corporations issuing them. Factors such as yield, maturity, face value, conversion premium, and industry are used to analyze the contracts. Factors such as debt to equity, leverage, standard deviation of earnings, are used to determine a correlation in the likelihood of issuing LYONs. Trading history is examined to determine which risk is best protected against by the attached put and call options, and whether corporations or investors are typically realizing the benefits