Miguel Viveros

Carlos Calderon
Robin Cyriax
Behavioral Finance
Citigroups Exchange Offer
CASE ANALYSIS
Question 1
Do you think the proposed conversion is a good deal for Citis preferred shareholders? Why or
why not? Why might Citi be willing to pursue the exchange on these terms?
From the perspective of Citis preferred shareholders the proposed conversion seems to be
a good deal. Citigroup is willing to convert the preferred stocks at a price which is significantly
above their market value. Specifically, they suppose a face value of $ 25 for the F-series of
preferred shares while they are actually trading for $ 8.14 in the market. This overvaluation
compensates for the negative fact that Citigroup will only take into account 95% of the face
value ($23.75) for the conversion and that they will sell the common shares to the preferred
shareholders at a price above market value. Common shares traded at $2.46 the previous day
and dropped down to $1.50 after the deal was announced, but Citigroup will apply a price of $
3.25 for them. The preferred shareholders nevertheless benefit from the exchange, because the
overvaluation of the preferred shares is bigger than the overvaluation of the common shares.
Citigroup is willing to offer this deal because the exchange would change preferred equity to
common equity in their balance sheet. This would significantly improve the TCE ratio (Tangible
Common Equity ratio), since only common equity is taken into account for it. Management
believed this accounting figure to be very important for investment decisions of future potential
shareholders and therefore was willing to pay a price for this.
In addition to improving the TCE ratio, Citigroup was paying a dividend to preferred stock
owners could reduce dividend payments by converting their shares to common stocks.

Miguel Viveros
Carlos Calderon
Robin Cyriax
Behavioral Finance
QUESTION 2
A. What is the relation between Citi common shares and preferred shares created by the
Exchange offer? (You should focus on the Series F Preferred shares.)
The exchange offer created the following relation between Citi common shares and preferred
shares is: LV PS x Exchange Factor (% of Liq. Value) / PoCS = Number of CS/ PS, where:
LV = Liquidation Value

PS = Preferred Shares

PoCS = Common Shares

For the F Preferred Shares, the following relation applies:

$ 25 x 95% / $3.25 = 7.308
This relation means, that shareholders would get 7.308 common shares for every preferred
stock. It also sets value of the preferred shares at $ 25 x 95% = $ 23.75 and the value of the
common shares at $ 3.25.
B. Describe the deviation of stock prices on 2/27/2009 from this relationship. Which
security is relatively undervalued?
The prices that were used for the conversion offer for both preferred shares ($23.75, F
series) and common shares ($3.25) were more or less randomly chosen by Citigroup and did not
correspond to the true market value of both securities. Common shares were trading at $1.50
and preferred shares (F series) at $8.14 on February 27th (day the deal was offered).
Taking into account the conversion ratio of 7.308 common shares/ preferred share (F
series), the preferred shares (F-series) should have been trading at 7.308 x $ 1.50 = $10.96. Since
this number is higher than their actual price of $8.14 in the market, we can conclude that the
common shares are relatively undervalued in the conversion offer.

Miguel Viveros
Carlos Calderon
Robin Cyriax
Behavioral Finance
QUESTION 3
Construct a trading strategy to exploit the apparent mispricing you uncovered in Question 2.
Build your initial balance sheet, being mindful to satisfy Reg. T.
Since we found that the common shares are undervalued, we want to go long on
preferred shares and sell common shares in the same ratio as the one Citigroup uses in their
conversion offer (7.308 common shares/ preferred share). In order to satisfy Reg. T, we put
aside 50% of the proceedings from shorting 7.308 common shares and finance only 50% of the
long position with a margin loan.
Assets
Proceeds from Shorting 7.308 CS
Collaterals for shorting
Long 1 Preferred Shares

Liabilities
10,96 Short Common Shares
5,48 Margin Loan
8,14 Equity

10,96
4,07
9,55

Total

24,58 Total

24,58

QUESTION 4
Describe the possible risks of the strategy you proposed in Question 3. Which ones do you find
most important in deciding how aggressively to trade against the mispricing? Be specific!
Basically we identify two risks for our trading strategy:
1) The conversion doesnt take place, i.e. because one of the institutional shareholders
(Singapore investors, US government) withdraws its commitment
In this case, we can expect common shares to rise back to a price of $2.46
2) The deal takes place but prices still move against our strategy (at least in the short run),
specifically preferred shares decrease in value while common shares increase in value.
In order to reflect these risks, we would only invest about 75% of the equity we have at hand in
this strategy (i.e. $750 out of $1,000). This would also allow us to adjust our position to satisfy
Reg. T requirements if the stock prices move against us at first.