Dual Directional Structured Products
Published in the Journal of Derivatives & Hedge Funds, (5 June 2014).
We analyze and value dual directional structured products - or simply dual directionals
(DDs) - which have been issued in large amounts since the beginning of 2012. DD's evolved
out of another type of structured product called absolute return barrier notes (ARBNs);
however, DD's lack principal protection and have different embedded options positions, which
have yet to be described in the literature. We find that DDs can be broadly organized into
two categories: single observation dual directionals (SODDs) and knock-out dual directionals
(KODDs). We determine the appropriate option decomposition for these categories and
provide analytical formulas for their valuation. We confirm our analytic results using Monte
Carlo simulation and use both techniques to value a large sample of DDs registered with the
Securities and Exchange Commission up to December 2012. Our results indicate that like
many types of structured products, DDs tend to be priced at a significant premium to present
value across issuers and underlying securities and that the present value of the decomposition
is smaller than the face value net of commissions. We find that DDs with embedded leverage
or a single observation feature tend to be worth less than products either without leverage
or with a knock-out option.
Are VIX Futures ETPs Effective Hedges?
Published in The Journal of Index Investing, Winter 2012, Vol. 3, No. 3, pp. 35-48.
Exchange-traded products (ETPs) linked to futures contracts on the CBOE S&P 500 Volatility Index (VIX) have grown in volume and assets under management in recent years, in part because of their perceived potential to hedge against stock market losses.
In this paper we study whether VIX-related ETPs can effectively hedge a portfolio of stocks. We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs. ETPs which track medium term VIX futures indices suffer less from negative roll yield and thus appear somewhat better hedges for stock portfolios. Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.
We also study the effectiveness of VIX ETPs in hedging Leveraged ETFs (LETFs) in which rebalancing effects lead to significant losses for buy-and-hold investors during periods of high volatility. We find that VIX futures ETPs are usually not effective hedges for LETFs.
Isolating the Effect of Day-Count Conventions
Day-count conventions are a ubiquitous but often overlooked aspect of interest-bearing investments. While many market traded securities have adopted fixed or standard conventions, over-the-counter agreements such as interest rate swaps can and do use a wide variety of conventions, and many investors may not be aware of the effects of this choice on their future cash flows. Here, we show that the choice of day-count convention can have a surprisingly large effect on the market value of swap agreements. We highlight the importance of matching day-count conventions on obligations and accompanying swap agreements, and demonstrate various factors which influence the magnitude of day-count convention effects. As interest rate swaps are very common amongst municipal and other institutional investors, we urge investors to thoroughly understand these and other `fine print' terms in any potential agreements. In particular, we highlight the ability of financial intermediaries to effectively increase their fees substantially through their choice of day-count conventions.
Optimizing Portfolio Liquidation Under Risk-Based Margin Requirements
Published in the Journal of Finance and Investment Analysis, 2(1): 121-153, 2013.
This paper addresses a situation wherein a retail investor must liquidate positions in her portfolio -- consisting of assets and European options on those assets -- to meet a margin call and wishes to do so with the least disruption to her portfolio. We address the problem by first generalizing the usual risk-based haircuts methodology of determining the portfolio margin requirement given the current positions of a portfolio. We derive first and second-order analytic estimates for the margin requirements given the positions. Given this generalization, we determine the liquidation strategy that minimizes the total positions liquidated and meets the margin requirement. We implement the strategy on example portfolios and show advantages over traditional piece-wise liquidation approaches. The analytic approach outlined here is more general than the margin context discussed. Our approach is applicable whenever an investor is attempting to maximize the impact of their capital subject to leverage limits and so has obviously applications to the hedge fund industry.
A Primer on Non-Traded REITs and other Alternative Real Estate Investments
Published in the Alternative Investment Analyst Review, 2014.
In this paper we provide a brief overview of the ways to achieve real estate exposure and focus our analysis on alternative real estate investments. The term alternative real estate investment, as used in this paper, refers to real estate securities such as non-traded Real Estate Investment Trusts (REITs), private REITs, and Tenants-in-Common (TICs), which are often sold to but may be unsuitable for most retail investors. Some common problems of alternative real estate investments are: 1) their illiquid nature allows them to give investors an illusory sense of low price volatility, 2) their high fees and significant conflicts of interests may lead to a loss of shareholder value, and 3) their reliance on leverage to fund current dividend payments may hide their inability to pay future dividends. Limitations on publicly-available data oblige us to concentrate much of our discussion on non-traded REITs. Our analysis is relevant for the even less transparent private placement REIT and TIC market.
CLOs, Warehousing, and Banc of America's Undisclosed Losses
Collateralized Loan Obligations (CLOs) are issued by trusts which in turn invest the proceeds from issuing the CLO securities in portfolios of bank loans. This note explains the conflicts of interest created when an investment bank accumulates loans for potential securitization prior to the issuance of a CLO through a practice known as 'warehousing.' Warehousing appears to have resulted in some CLO trusts issuing securities without disclosing to investors that the securities had lost almost all their value because the CLO trust was committed to paying substantially more than the market value of the warehoused loans.
We provide two examples of such problematic CLO offerings in which Banc of America appears to have transferred at least $35 million of losses to investors in July 2007 and which ultimately led to approximately $150 million in losses in just these two CLOs. $35 million of those $150 million in losses occurred before Banc of America sold the securities to investors and only $115 million occurred after investors bought the CLO securities. The problem we identify is more widespread than Banc of America and broader than CLOs.
The Private Placement Memoranda for the products mentioned in the paper:
- Bryn Mawr II PPM
- LCM VII PPM
- Symphony IV PPM
The LCM VII Marketing Deck and the LCM Trustee Reports which document the decline in the value of the LCM VII loans before July 31, 2007 are available to read.
- American Banker - B of A Subpoenaed by Massachusetts Over CLOs by Allison Bisbey
- The New York Times, February 5, 2012 - A Wipeout That Didn't Have to Happen
- Hayes v Banc of America Securities - $1.4 million CLO Award
Valuing Partial Interests in Trusts
The financial interests of a trust's beneficiaries are often diametrically opposed and conflict among trust beneficiaries is common. Although applicable law requires that trustees adhere to lofty standards of 'good faith' and 'fair dealing' they must make tangible, specific decisions, and sometimes under circumstances in which the settlor's expectations regarding investments and distributions as set forth in the trust document are unclear. Traditional methods for valuing partial interests in trusts offer insufficient guidance to courts in assessing the prudent investor standard, as they often disregard many of the important factors which go into investment decisions--notably, the allocations to different asset classes.
In this paper, we develop a valuation methodology based on Monte Carlo Simulation techniques which allows for economically feasible ex ante valuation of partial interests in trusts. The MCS technique is widely used in modern finance and economics, and is especially useful for valuing partial interests because it can incorporate mortality risk, portfolio asset allocation, varying distributions and the discretionary sale of the trust's assets to fund distributions. We explain how the MCS method can incorporate a variety of assumptions about the income beneficiary's mortality and the trustee's decisions, and show how these factors affect the valuation of partial interests.
Rethinking the Comparable Companies Valuation Method
This paper studies a commonly used method of valuing companies, the comparable companies method, also known as the method of multiples. We use an intuitive graphical presentation to show why the comparable companies method is arbitrary and imprecise. We then show how valuations can be significantly improved using regression analysis. Regression analysis is superior to the comparable companies method because, by using more of the available data and imposing fewer unreasonable assumptions, it is more accurate and can value more firms.
The Properties of Short Term Investing in Leveraged ETFs
Published in the Journal of Financial Transformation, Fall 2012, Journal 35.
The daily returns on leveraged and inverse-leveraged exchange-traded funds (LETFs) are a multiple of the daily returns of a reference index. Because LETFs rebalance their leverage daily, their holding period returns can deviate substantially from the returns of a leveraged investment. While about half of LETF investors hold their investments for less than a month, the standard analysis of these investments uses a continuous time framework that is not appropriate for analyzing short holding periods, so the true effect of this daily rebalancing has not been properly ascertained.
In this paper, we model tracking errors of LETFs compared to a leveraged investment in discrete time. For a period lasting a month or less, the continuous time model predicts tracking errors to be small. However, we find that in a discrete time model, daily portfolio rebalancing introduces tracking errors that are not captured in the continuous time framework. On average, portfolio rebalancing accounts for approximately 25% of the total tracking error, and in certain scenarios the rebalancing tracking error could rise to as high as 5% in 3 weeks and can dominate the total tracking error. Since investors in LETFs have short average holding periods and high average turnover ratios, the effects of portfolio rebalancing must be accurately accounted for in the analysis of LETF returns.