Marcelle Arak

Do Daily Price Limits Act as Magnets? The Case of Treasury Bond Futures

This article examines price behavior in the U.S. Treasury bond futures market in the mornings after large overnight price moves, using data from 1980 to 1987. The article tests whether price behavior is affected by proximity to a price limit, and whether the effect is a magnet effect or a calming effect. In that period, the price tends to reverse direction after the morning open, and the reversal appears to reflect a calming effect of the price being close to the limit. An alternative hypothesis—that morning price behavior reflects the overnight price change rather than proximity to the price limit per se—is also tested, and does not perform as well in explaining price behavior.

Interest Rate Swaps: An Alternative Explanation

n The interest rate swap market, first developed in 1982, had an estimated annual volume of more than

Convertible Bonds: How Much Equity, How Much Debt?

360 billion in 1987.1 Various reasons have been given for the existence and growth of the market, ranging from comparative advantage arguments to agency cost explanations to tax and regulatory reasons. However, each of the explanations is in some way inadequate in explaining the phenomenal growth of the market. Prior to the introduction of swaps, the only instruments available to borrowers were long-term fixed rate, long-term floating rate, and short-term debt. The combinations that were possible with those instruments are shown in Exhibit 1. The introduction of swaps brought additional options to borrowers. When combined with short-term borrowing in the credit markets, swaps enable borrowers to fix the risk-free component of their interest costs while allowing the credit risk components to fluctuate. This ability to provide borrowers with previously unattainable alternatives is the characteristic that makes swaps a true, and probably enduring, financial innovation.

Yields on Privately Placed Debt: Examining the Behavior

Financial analysts need accurate estimates of debt, equity, leverage, and EPS. The method proposed here, based on the probability of conversion, yields new estimates of the debt and equity in a convertible bond issue. When this method is used, the value of the equity component in a hypothetical issue is found to be substantial—larger than the value of the options and clearly larger than zero, which is assigned under current accounting rules. The estimate of the debt component is smaller than recorded under current accounting rules. Thus, the leverage of convertible bond issuers is substantially lower when this method is used. Convertible bonds, which can be converted into shares of the issuers stock, have some probability of remaining bonds and some probability of being converted into stock. Although, on the face of it, these bonds seem to be part debt and part equity, under current accounting rules, convertibles are counted entirely as debt until converted or paid off. We discuss a new approach for determining the debt and equity portions of a convertible bond that is consistent with modern finance theory and grounded in economic reality. In this approach, we view convertible bonds as part equity, part debt, with the proportions depending on the probability of conversion, and show how that treatment affects the analysts picture of the companys financial structure. Using a typical convertible bond structure, we illustrate our method of estimating the embedded equity and contrast the results with those found by following current accounting guidance and those based on the straight bond/option decomposition. Our measure of the equity component of the convertible bond is substantial—larger than the value of the embedded stock options and also larger than zero, which is the amount of equity assigned to a convertible issue under current accounting rules. The debt component, measured by our method, is much smaller than the total value of the convertible and also much smaller than the value of the straight bond (the value of the convertible bond minus the options). As a consequence, the leverage calculated with our method is substantially lower than that based on the two other methods. Over time, of course, the probability of conversion changes, and so do the debt, equity, and leverage of the issuer derived from our approach. The probability of conversion can also be applied to estimate dilution. According to our method, the shares attached to the convertible issue during the bonds life are many fewer than the total potential shares, the measure used under current accounting rules to calculate EPS. Consequently, EPS is higher under our method until the bond is converted. Financial analysts need estimates of leverage and EPS that reflect economic reality. As we show, the difference between the numbers derived from our method and the numbers resulting from the current accounting rules is too large to ignore. The current accounting rules create a distorted, highly negative view of the capital structure and EPS of convertible bond issuers at the time of issue. Unless the accounting profession embarks on a dramatic rethinking of equity embedded in convertible issues, financial analysts will need to do their own calculations; we provide a method for doing so.

The effect of the new risk-based capital requirements on the market for swaps

PATRICK J. CORCORAN is vice president at Nomura Securities International Inc. in New York (NY 10281-1198). P rivate placements have been a significant part of the corporate debt market in recent years. In some years in the late 1980s, privately placed notes and bonds accounted for about 40% of new corporate fixed-income securities issued. And since the SEC established Rule 144A in 1990, there are private issues that can be traded among institutions, creating more of a secondary market. As yet, however, relatively little :is known about how yields on private placements behave. Do yields on privately placed notes and bonds tend. to mixor the behavior of comparable-quahty public (debt issues over time? How do private placement yields behave as the economy weakens or strengthens? Carey, Prowse, and Rea [1993c] examine yields on private placements over the past few years (1990-1992) and find a stark contrast between the behavior of investment-grade yields anld below-investment-grade yields. They attribute this difference to a credit crunch that affected below-irtvestment-grade paper, including private placements that were below investment grade. While this is plausible, the study is based on limited quantitative information about the private placement market (mainly from surveys of market participants). This article sheds some new light on the behavior of private placement yields, with the advantage of previously unpublished data collected fclr many years by the Prudential Insurance Company of America. Our analysis of these data suggests that:

Risk and Return in Trading Closed-End Country Funds: Can Trading Beat Holding Foreign Stocks?

The new risk-based capital requirements for banks cover swap agreements as well as the normal on-balancesheet items. The capital calculation is based on a fixed small percentage plus the current market value of the swap, if it is positive. Using option valuation methodology, anticipated capital requirements over the life of a swap are calculated. These requirements are compared to cushions that banks might want to hold against the risks of above average loss rates. For interest rate swaps, the cost of the capital requirements is small, amounting to about 1 bp/year on a swap; in a matched pair, this would amount to 2 bp in the bid-offer spread. On currency swaps, the cost of the capital requirements appears to be much more substantial, closer to 4 bp per year on a swap. In a matched pair, the excess of the capital requirements over desired cushion could amount to 7 bp in the bid offer spread.

PEG Ratios: What Makes Sense?

The discounts of closed-end country funds, from their net asset value, vary substantially from week to week. Statistical tests in this paper indicate that these discounts are mean reverting and therefore the discount has a predictable component. We investigate whether additional returns can be gained from a strategy of switching from equities into the closed-end funds when the discount is large and selling the fund and rebuying equities when the discount narrows. Because only limited data exists for closed-end country funds, we use Monte Carlo simulations to calculate the expected returns from the strategy. These simulations show that substantial profits, over and above the returns on the portfolio of foreign stocks held by the fund, can be earned. One drawback to investing in these country funds is that their prices tend to be more highly correlated with the US market than their portfolios are. We estimate the relevant betas and compute the additional returns necessary to compensate the investor for the additional systematic risk. After netting out the risk compensation, substantial abnormal returns remain.

The Direction of Crude Oil Prices: The Role of Market Structure

High price-earnings ratios are often justified by high growth rates in corporate earnings. In recent years, many analysts have turned to the ratio of the PE ratio to the growth rate (the PEG ratio) in an effort to control for this relationship. In fact, the PEG ratio is not a constant that can be used to decide whether a stock is cheap or not. Rather, a plot of the relationship of the justifiable PEG to the growth rate is u-shaped for a wide range of parameter values. The level of the justifiable PEG for a given growth rate also depends on the length of the rapid growth period, the sustainable growth rate in the long run, and the discount rate. The PEG levels of 1.0 or 1.5 sometimes cited by analysts are more difficult to justify than some might suppose.

Stock Exposures in Portfolios with Options

This article focuses on the price inelasticity of demand for crude oil in the short run and its implications. We show that any producer with a share greater than the elasticity of demand, weighted by its profit margin, could benefit by curbing supply to increase profits. This means high cost producers have a lower threshold to meet before they can profit from a reduction in output. It also implies that high cost producers without major shares may benefit, albeit not as much as those who free ride on cuts by others. We note that the increased competitiveness of the global oil market and differing national preferences may be preventing cooperation that would benefit many producers.

Treasury bond futures: Valuing the delivery options

THE JOURNAL OF WEALTH MANAGEMENT 19 I nvestors commonly look at each stockholding as a percent of their overall portfolio’s value in assessing their portfolio’s diversification. Outright stock holdings are only a part of the picture, however. Many high-net-worth individuals also have positions in stock options. They may have bought call options in order to expand their upside opportunity in a particular stock; or they may have bought put options in order to protect against the downside possibilities on a large stock position. In addition, many senior executives have been granted large quantities of equity options (calls) on their company’s stock—indeed a lion’s share of CEO compensation is in the form of stock options in recent years. Those familiar with option theory know that options on a particular stock may give the holder additional exposure to that stock (e.g., long call options or employee stock options (ESOs)) or reduce exposure to that stock (e.g., long puts or short calls against a stock holding.). A qualitative assessment of the effect of stock options—figuring out whether they increase or reduce exposure—is easy. The more complex issue is figuring out exactly how much option positions affect the investor’s exposure to individual stocks. Investors with experience in using options know that options on shares cannot simply be added to (or subtracted from) shares of stock held outright to get an intelligent picture of the investor’s portfolio. Professional option traders have specialized software to combine options on certain assets with outright positions on those same assets; some portfolio managers have mathematics/software to figure out the volatility of portfolios that include options (see Lewis [1990], Marmer and Ng [1993], and Sheedy and Trevor [2000], for example). The typical high-net-worth investor, however, one who has a few options positions, or a large quantity of ESOs, does not have a simple way of examining the diversification characteristics of his/her portfolio. Most brokerage statements and commonly used asset management software offer little help on how to handle such options and figure net exposures. In fact, many of the simple approaches are wrong!! Yet, these options positions—particularly ESOs—can dramatically affect the person’s stock concentrations. This article describes a procedure for combining options with outright stock holdings to get an accurate view of overall exposure to each company’s equity price. The method is simple and does not require complex software. Broader allocations such as sector holdings as well as stock/bond allocations can also be calculated by extending the methodology. This article does not address the issue of how to alter overconcentrated portfolios—in itself an important issue—but helps the investor/advisor to identify them, an important first step. For an approach to optimal diversification, the reader should see a recent conference presentation by Stein and Siegel [2002], who describe dynamic diversification schemes involving option exercise. Stock Exposures in Portfolios with Options