Karan Bhanot

Recovery and Implied Default in Brady Bonds

vidence in t h s article shows that default probabilities implicit in Brady bond prices are significantly different from those so far obtained in the literature if partial recovery is assumed (see, for example, Claessens and Pennach [1996]). We compute implied default as a function of recovery rates in a numerical example. The results suggest that loans to foreign borrowers should be valued at higher spreads than stripped spreads on Brady bonds if zero recovery is the desired assumption. Durations based on no-recovery are different from those calculated by standard models and shown in the literature (e.g., Boudoukh, Richardson, and Whitelaw [1996]). The usefulness of these results is seen in an application to Argentinian par bonds in the Brady bond market.

Value of an option to purchase electric power -- the case of uncertain consumption

Abstract Large manufacturers and corporations often purchase options on power to protect themselves against unanticipated price increases. This paper analyzes the impact of uncertainty in power consumption by a corporation on the value of an option to purchase electric power. Because there is no economically viable method to store power, these options are exercised to satisfy immediate consumption needs only. The amount exercised may differ from the maximum amount contracted, which in turn alters the payoffs that accrue to the option contract. We apply a Monte Carlo methodology to show that ‘consumption uncertainty’ may substantively lower the price of an option contract under different conditions.

Anatomy of a Government Intervention in Index Stocks - Price Pressure or Information Effects?

In a massive intervention designed to deter speculators, the Hong Kong Monetary Authority (HKMA) bought Hang Seng index stocks in August 1998. These stocks experienced a 24% abnormal return during the intervention period. The abnormal returns are not reversed over the next eight weeks, refuting the hypothesis that returns are due to temporary liquidity effects. Cross-sectional analysis of daily abnormal returns during the intervention period reveals that these returns are related to overall intervention activity rather than stock-specific intervention. This evidence is consistent with information effects rather than price pressure effects.

Negative credit spreads: Liquidity and limits to arbitrage

Recent reports in the financial press regarding negative spreads in the investment-grade corporate bond market have drawn the attention of policy makers and market participants alike. Using a sample of investment-grade corporate bond yields for the period 9/2009 to 9/2010, the authors examine all data points where the trade price reflects a negative spread. There are a total of 67 instances distributed among 10 companies where the credit spread is negative based on reported trade prices. The observed credit spread does not violate arbitrage restrictions once the bid–ask spread and liquidity are accounted for. In terms of default risk, CDS prices are higher than the bond yield spread on these days, but funding and asset-specific liquidity constraints possibly limit the ability to exploit the arbitrage.

Dynamics of Credit Spreads: A Non-Parametric Analysis

This article uses a particular non-parametric approach to examine the conditional drift and variance of credit spreads. The data include Moodys Aaa and Bbb seasoned bond index yields for the period February 1977 through May 2001. The results show that the drift function is linear and mean-reverting for Aaa index spreads, but Bbb spreads show a strong non-linearity in the drift function. Around its mean, the drift of Bbb spreads is essentially zero, behaving like a random walk, but it mean-reverts strongly when far away from the mean. For pricing and hedging applications, the affine class of parametric diffusion specifications is therefore likely to work well for Aaa spreads, while a non-linear specification is preferable for Bbb spreads.

The New Market for Treasury Floating Rate Notes

Treasury Floating Rate Notes (FRNs) were introduced in 2014 as a way to diversify the U.S. Treasury funding base and lower its borrowing costs. Using daily data on all Floating Rate Notes issued from 1/2014 to 10/2016 we find that FRNs deliver a statistically significant excess return relative to the underlying index, as well as relative to other short-term interest rate benchmarks. However, yield spreads with respect to comparable maturity fixed rate Treasuries, quarterly data on auction outcomes, and block holding disclosures by financial institutions support the objectives set forth by the Treasury. Collectively our article provides a perspective on FRN contract features, the return and risk of these instruments, and insight into their clientele.

Limits to Financialization of a Production Firm

Should commodity producers that engage in trading keep production and trading operations together or divide them into separate entities? A joint firm can substitute production with trading when switching capacity is expensive, and use the shared balance sheet to exploit trading opportunities. However, a joint firm unable to ring-fence a profitable operation, and is vulnerable to shocks in one operation that contaminates the other. Trading to support and hedge production adds value. Trading to expand the profits of the company must be limited below a threshold. Excessive trading is characterized by its scope in the joint firm.

Pay Now or Later: Financial Flexibility and Security Design

Recent years have witnessed a proliferation of new types of debt securities. Amongst these, PIK-Toggle bonds give a borrower the choice between rolling over coupon payments by issuing additional bonds or paying the coupon in cash. Despite their controversial nature, we show that for a firm facing liquidity constraints and the possibility of diversion of cash flows, the optimal contract includes an option to skip coupons and automatically increase leverage. This contract combines active rebalancing of debt with the management of the firm’s cash balance and its dividend policy. The optimal contract is preferable when the firm’s expected cash flows are low relative to the costs of servicing the debt; the firm’s cash flows have temporary low Sharpe ratio; and debt restructuring is costly.

WILL PULLING OUT THE RUG HELP? UNCERTAINTY ABOUT FANNIE AND FREDDIE'S FEDERAL GUARANTEE AND THE COST OF THE SUBSIDY

Comments by the Federal Reserve Chairman often evoked concerns about whether the government would protect bondholders in the event of default by Fannie Mae and Freddie Mac (F&F). Using a model of capital structure, we analyze the impact of this uncertainty on the value of the implicit subsidy for F&F (and similar institutions). We show that, counter to intuition, an increase in the likelihood that the government will not subsidize these entities via a guarantee may increase the expected cost of the subsidy to the federal government. A cap on the value of the investment portfolio is a more effective mechanism to reduce the risk exposure of the federal government. We also assess the design and impact of proposed receivership rules and highlight the problems in regulating GSE portfolios. Even though F&F are now in conservatorship, the framework is applicable to other government sponsored entities where there is ambiguity about the extent of government backing.

Stability of Transition Densities: Evidence from Competing Interest Rate Models

Application of continuous-time models for changes in the short-term interest rate amounts to specifying a corresponding transition density for interest rates. The author empirically evaluates the time series of transition densities obtained from popular interest rate models when implied parameter estimates from the options markets are used. The integrated absolute difference between transition densities obtained in successive periods provides a convenient method to evaluate out-of-sample performance of a model. The procedure is used to evaluate four competing modes with the data from the Eurodollar futures and options market for the period 1985–1999.