Christian Koziol

Valuation of Bond Illiquidity

In this article, the authors present an easily applicable option-theoretical approach to quantifying liquidity spreads of bonds. Following Longsta [1995], they describe the value of liquidity as that of exotic options. After valuing these lookback options in a framework with interest rate uncertainty, this approach yields liquidity spreads for bonds that cannot be traded continuously. The liquidity spreads show plausible properties: they are humped-shaped functions of the maturity and increase with the interest rate volatility. Liquidity spreads depend on the distribution of possible trading dates but are independent of the short rate. Regarding German Jumbo Pfandbrief market data, they find several parallels between theoretical and empirical liquidity spreads, while credit risk has nearly no explanatory power.

Bond portfolio optimization: A risk-return approach

In this article, the authors apply Markowitz’s approach of portfolio selection to government bond portfolios. As a main feature of the analysis, the term structure models is used to estimate expected returns, return variances, and covariances of different bonds. The authors’ empirical study for the German market shows that a small number of risky bonds is sufficient to reach very promising predicted risk-return profiles. If the number of risky bonds in the portfolio is not too large and the term structure model does not contain more than two factors, these predictions are confirmed by the realized risk-return profiles.

Optimal exercise strategies for corporate warrants

In this paper, we analyse the optimal exercise strategies for corporate warrants issued by levered firms. For the analysis, we distinguish between two exercise variants, namely the traditional block exercise and competitive exercise in equilibrium. We find that the optimal exercise date under the block condition can be before or after an optimal exercise in equilibrium. Surprisingly, optimal block exercise can occur even without any dividend payments in contrast to the competitive exercise. As a consequence, the asset values and the stock volatility under block exercise fundamentally deviate from those under the competitive exercise variant. Moreover, the value of a warrant in the block case and its exercise strategy do not coincide with those of a corresponding call option which contrasts with the assumption of ‘option-like’ warrant valuation.

Are Private Equity Investors Boon or Bane for an Economy? - A Theoretical Analysis

In this paper, we provide a theoretical foundation for the controversial debate on the investment behaviour of private equity investors. We separately consider six major characteristics that typically distinguish private equity investors from standard investors. Applying a simple model framework, we compare both the maximum acquisition prices paid by private equity and standard investors for the takeover of a target firm, as well as the subsequent optimal investment volumes. This analysis intends to uncover why private equity investors do (or do not) acquire a company even though they later invest less than standard investors would. We find that most of the usual arguments against private equity transactions, such as higher target return, short‐term investment perspective, lower risk aversion, and operational improvements, cannot explain lower investment volume following a successful takeover by private equity firms, in contrast to other arguments, such as high level of leverage and informational advantages.

Do good or bad borrowers pledge more collateral

Purpose - The purpose of this article is to determine the optimal use of collateral in order to maximize the borrowers wealth by reducing the interest rate payments. This analysis is to shed light on the fundamental question whether good or bad borrowers pledge more collateral. Design/methodology/approach - The analysis bases on a simple firm value model similar to Mertons but with the additional feature that the borrower can bring in collateral. This article not only presents the case with perfect information between borrowers and lenders but also regards the consequences arising from asymmetric information. Findings - A bad borrower, who is characterized by higher bankruptcy costs, riskier projects, and a lower contribution to the project value, typically pledges more collateral than a good borrower. These relationships base on the existence of perfect information between borrowers and lenders. If asymmetric information in terms of the projects riskiness or the contribution of the borrower to the project is present, these relationships invert and good borrowers tend to pledge more collateral. As a result, the allocation of information between a borrower and a lender is crucial for the optimal choice of collateral. Research limitations/implications - This research underlines the potential for firms to add firm value by pledging collateral because collateral reduces interest rates and therefore results in more attractive terms of the loan. On the other hand, further empirical research can be done to verify our theoretical finding that under perfect information bad borrowers pledge more collateral, while under asymmetric information primarily good borrowers use collateral. Originality/value - This paper introduces a new motive for the use of collateral and explains – in contrast to many other theoretical models – why bad borrowers tend to pledge more collateral.

When does single‐source versus multiple‐source lending matter?

Purpose – Seek to compare the consequences of single-source versus multiple-source lending for a borrower who has loans that can be prematurely terminated. Design/methodology/approach – The considered model framework is an option-theoretic firm value model similar to Merton (1974) but where lenders have the additional right to prematurely terminate the loans. The single lender is a monopolist, while multiple lenders are represented by a continuum without individual impact on the aggregate termination decision. Findings – The model explains that, if the borrower is in financial distress but has positive net present value projects, a single lender has a higher incentive to save the firm and therefore terminates fewer loans than multiple lenders. In the opposite case where the firm is not under financial distress, it is the other way round and multiple lenders terminate fewer loans than a single lender. As a result, equity holders are better off by having a loan from a single-source under financial distress but multiple-source lending is advantageous in the absence of financial distress. Research limitations/implications – To focus on the origin for arising differences from single-source and multiple-source lending, consideration is given to the simple case with perfect information and without monitoring and renegotiation. These market imperfections can be incorporated into the model in a straightforward way. Originality/value – While other models in the literature require market imperfections to explain the relevance of the bank relationship, this paper indicates that even in the absence of market imperfections the lending relationship is fundamental as long as lenders have the right for early terminations.

What drives contagion in financial markets? : liquidity effects versus information spill-over

The objective of this paper is to study how contagion works in financial markets by identifying the mechanisms which drive the spill-over of shocks from one market to other markets. To address this question we use open-ended property funds (OPFs) as they offer a unique institutional setting which allows separating between liquidity and information spill-over. We find that that liquidity risk captures the observed discounts very well when the danger of potential future impairments is low. Once the impending NAV impairments become very likely, also this component matters and attributes for a fraction of the total discount.

Do Institutional Investors Care About The Ambiguity Of Their Assets? Evidence From Portfolio Holdings In Alternative Investments

In this paper, we analyze whether model risk/asset-specific ambiguity is an issue for institutional investors. For this purpose, we first show how model risk (which turns out to be equivalent to special cases of ambiguity) affects optimal portfolio allocation. Using average portfolio holdings for traditional and alternative asset classes of 119 institutional investors, we then calibrate our model to implicitly determine the ambiguity factors of different asset classes. We find that institutional investors are strongly ambiguity-averse, as documented by a Sharpe ratio that is only 60 percent that of an (unambiguous) efficient portfolio. In line with intuition, we document that equity and bond portfolios have a rather low ambiguity, while alternative investments such as real estate, private equity, and hedge fund investments exhibit a very high ambiguity. These results are robust with regard to the size of the expected returns supposed by the investors.

OPTIMAL CREDIT RATINGS

In this paper, we show that an individual optimal credit rating exists for firms and empirically test whether firms strive to achieve their optimal rating. For this purpose, we consider the structural model by Leland [12], which balances the benefits of debt in the form of the tax-deductibility of interest payments against bankruptcy costs in order to obtain the optimal rating. Testable implications for both firms which have implemented their optimal rating and firms with non-optimal ratings are deduced. An empirical test with 420 firms contained in the S&P 500 Index indicates that all factors which theoretically drive optimal ratings also affect the observed rating in the predicted way. In line with our theory, observed ratings can be considerably better explained if, in addition to the traditional factors such as leverage and firm size, a proxy for bankruptcy costs and the default probability related to the optimal rating is considered. These findings suggest that U.S. firms contained in the S&P 500 Index strive to achieve their optimal credit ratings.

Optimal Debt Service: Straight vs. Convertible Debt

In this paper, we analyze the optimal default strategy of a firm when debt is convertible into equity. For this purpose, we consider a convertible consol bond in a time-independent model in the presence of bankruptcy costs and tax de-ductibility. The optimal default and conversion strategy result from a game be-tween equity and debt holders. A closed-form solution for the optimal default barrier exists if the firm pays no dividends. We show that an optimal default of convertible debt occurs earlier than a default of otherwise identical straight debt. A further comparison of the optimal default strategy with the strategy for straight debt shows that the value of convertible debt is lower when the firm follows the optimal strategy rather than the strategy for straight debt. Furthermore, we find that the important difference between the default barrier for convertible debt and identical but non-convertible debt rises with the conversion ratio, the coupon, a lower tax rate, and a lower payoff rate.