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WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS |
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ÖHave I Got a Deal for You!TM (5/28/99)Last Revised: 5/28/99. How to stub your toe ... Revised: 3/28/99. Spam! Spam! Spam! Spam! Follow Up. 9/28/98. Straight and Kinky Ways to Score Cash. Revised: 5/28/98. Enter the Dragonfly. Revised: 4/30/98. "Arbitrage" in the Real World #2. A discussion of a Derivatives Deal or Product – an Exotic Option, Structured Product, Embeddo, etc. (Look them up in the Derivatives Dictionary.) If you run across an interesting product, trade, deal, or strategy, can't quite figure out what the catch is, and wouldn't mind it showing up here – perhaps without your name attached – tell Dr. Risk about it. He will analyze and discuss the most interesting deals and products here. He regrets that he will not be able to provide each of you with a complete analysis, because of the volume of suggestions, but will try to respond to each of you. How to stub your toe without leaving your easy chair (5/28/99)Question:Dear Dr. Risk – I would appreciate it if you could enlighten me on the subject of Stub trading (pair of cross holding companies). – Widget Answer: Dear Widget – Sorry, but the term's a new one on me. Give me a lead and I'll try to make sense of what I see, and then follow up. – Dr. Risk Question:Dear Dr. Risk – I was asked in one of my job interviews and I still could not properly understand it inside out. The story goes like this: Consider two companies A and B. A owns 50% of B. If stock A is overvalued relative to stock B (how to determine this?), then the strategy would be long 1 B, sell 0.5 A. If stock A is really overvalued then we can theoretically own stock B at less than its NAV. I think the crux of this strategy is to own B at less than its NAV. – Widget Answer: Dear Widget – Thanks for the additional facts. Now, I think I see what it's all about. First, let's look at a case that's more familiar. Consider closed end investment company, A. For clarity, it owns only shares in B and is selling at a discount to NAV, i.e., for less than NAV. To make an arbitrage profit, you borrow enough money to buy control of A, sell the shares of B for NAV, liquidate A, pay off your borrowing, and keep the extra. People claim to do this. Second, suppose that A is selling at a PREMIUM to NAV. So the way you make money is to control A, have it borrow a million or billion dollars, use that money to buy shares of B, and watch the value of A go up, as the market values those shares in the hands of A at greater than NAV. In other words, you do the opposite of liquidating a closed end fund. You expand it. Now, in your situation, you can own the fraction a of 50% of B and sell the fraction a of A. You are buying B cheap and selling it dear as part of A. Wow! We've found a money machine. After you've followed this plan, please email Dr. Risk. He'll send you the number of a Swiss bank account where you can deposit his share of the profit. – Dr. Risk Question: Dear Dr. Risk – Thank you Doctor....I feel better now. – Mannie Spam! Spam! Spam! Spam! II (8/28/98) and Follow Up!Question: To: DoctorRisk The top-rated Wall Street based P. J. Morgan Newsletter has initiated a "strong buy" recommendation on: Mark I Industries, Inc. THEY ARE PROJECTING A $4.00 SHARE PRICE SHORT-TERM (BY THE END OF THIS YEAR)! M K I I is a featured buy based on a thorough technical and fundamenral analysis of the company. Earnings are estimated to go from $.05/share in fiscal ‘98 to $.23/share in 1999. Furthermore, a large short position in the stock needs to be covered (bought) which will only increase the upward momentum. P. J. Morgan has M K I I rated a strong immediate BUY as well as a long-term hold position. For further information on M K I I go to:http://quote.yahoo.com/ – advisor83098@best.com Answer: Dear advisor83098 – Thanks for sending me three separate messages, any one of which would have been a perfect example of spam hyping a stock. Please excuse me for answering your message with a lot of questions:
– Dr. Risk Question:Dear Dr. Risk – This morning I received a message identical to the one that you quoted. I was suspicious, and started watching it. Also surfed around a bit to try to uncover anything substantive on the company named. I found your note from 8/28, and it confirmed my suspicions. If I had purchased the stock this AM, I would have paid 2x Friday's close, and would be up 50% right now (based on early ask and current bid) However that's all hindsight, and there's no telling what would have happened if I had put in any orders of sufficient quantity to have made a difference for myself. I stayed out, believing that the risk of buying an unknown stock outweighed any possibilities of catching a short-lived spike on a hyped stock. I just want to express my appreciation of your publication of this company's previous attempt to spam their way to a higher valuation. I wish the SEC would take an active interest in prosecuting this type of activity. You may publish my remarks, if you wish. Please do not use my name. Best regards – "Mannie" Answer: Dear Mannie – Thanks for your message about the spam hyping that company, and sharing your views and experience. Concerning those 50% gains. I can tell you are not devastated about missing them, and I'm glad. Did you see the article in today's WSJ about Stratton Oakmont. Some of their stocks were like roach motels -- easy to get into, but you couldn't get out, so you couldn't take your profits. You could order the broker to get you out, but if they didn't want to let you out, then in you stayed, and after they failed, SIPC wouldn't make you whole. We don't know how the dealers making markets in this stock would behave, but then we can't be sure that the unexplored parts of the moon aren't made of green cheese, either. We differ on one point. I don't so much wish the SEC would prosecute this sort of activity as I wish that people wouldn't give money so easily to strangers. The SEC can't do it all. The markets are too big, and legal hurdles for convicting crooks are too high. However, lowering those hurdles would create problems, too, as the SEC sweep would pick up lots of market players who I would probably think were "legitimate". I prefer to put the burden on the investor. So, I guess I'd say you're doing your bit, doing research, exercising judgment. Keep it up, and I hope you have some good luck, too! Even the smartest investors can use a lot of that. – Dr. Risk Question:Dear Dr. Risk – I see your point regarding SEC enforcement. It would be too easy to catch the good with the bad, and would likely chill the free discourse which our forefathers worked and fought so hard to obtain for us. The phrase "A fool and his money are soon parted" will hold true no matter how much enforcement there is. In a free society, people are free to make mistakes, make bad investments, etc. Removing that freedom moves our society away from overall freedom. Point taken. – Mannie Answer: Dear Mannie – Well said. Spread the word. – Dr. Risk Question:Dear Dr. Risk – We had a short email conversation in October regarding this email hyping of stock MKII. The email that I had received was identical to that on your website. Just FYI, the email promised $4.00/share by end of 1998. Now it's $4.00 for a hundred shares. (Bid 0.04, Ask 0.045) Good work! Happy Holidays – Mannie Answer: Dear Mannie – Yikes! I guess their forecast was off, just a bit! Thanks for keeping me in the loop. – Dr. Risk Straight and Kinky Ways to Score Cash (9/28/98)Question:Dear Dr. Risk – As my first port of call for all things derivatorial, I wondered if you could spare me a moment to discuss reverse convertibles, including how they differ from straight bonds? I hear they're all the rage in Europe. – "Spyder" Andrews Answer: Dear Spyder – For some people, a "straight" corporate bond is like "straight sex" – it gets the job don, but it's not very interesting. We'll leave the discussion of straight sex and its kinkier alternatives to Dr. Ruth, Dr. Drew, Mr. Starr, and President Clinton, but Dr. Risk wants to celebrate straight and kinky ways that a corporation can raise cash. The short answer: In essence, a reverse convertible bond is all of the following:
If that brief answer doesn't do the trick for you, let me expand this discussion, below.. REVERSE CONVERTIBLE The reverse convertible bond is a bond with an embedded short, European "put on shares, call on bond." The expression in quotes, in line with standard currency option terminology (e.g., "put on yen, call on dollar"), indicates that the option is really to exchange two risky assets – i.e., it's a "Margrabe" option. One might equally well term it either a put on the shares or a call on the bond, but either expression is only half the truth. Lately, in Europe, the issuer is a bank, the bond is the bank's own debt, and the shares are of some blue chip company. The bond would ordinarily need to promise a relatively large coupon to compensate for the embedded, short option. Let's assume that the bond matures at TM. Denote the share price at value date (t=0) by S and at expiration date (t=T<TM) by S(T). Similarly, let B and B(T) denote the bond price at those dates. The payoff for a reverse convertible bond is B(T) - Max[0, B(T) - g S(T)], where g is the conversion ratio (shares/bond). Oversimplifying – which here means that the bond issue is a small part of the appropriate capital structure, that all price movements are lognormal, and that bond coupons and share dividends are continuous and proportional to bond and share value – and using the model and notation of Margrabe (1978), plus the obvious extension to nonzero coupon and dividend yields, the value of such a bond would be RCB = e-cT
B - [e-cT B N(d1
) - e-dT g S N(d2)] where c denotes the bond's current yield and d denotes the shares' dividend yield. Consequently, the buyer of the reverse convertible bond is bullish on both the bond and stock markets and has a diversified position. The bank that issues a reverse convertible is short the bond and long an option to exchange shares for the bond. It can dump the shares on the bondholder at the put date if the share price tanks and/or interest rates drop, sufficiently. The reverse convertible could be a good issue if the embedded option is cheap – i.e., the increase in coupon on the debt is relatively small, compared to the value of the put option. The bank benefits greatly from the reverse convertible, compared to the straight bond, when the share price tanks, the bond market soars, it exercises its option, and it issues debt at a much lower coupon and retires some shares. Of course, if the option expires when the underlying bonds mature (T=TM), the issuer doesn't factor cheap refunding into his decision – these bonds would disappear, anyway. The bond's buyer is long the bond and short the exchange option, and will take a hit precisely when the issuer scores big. The reverse convertible outperforms the straight bond most, when the bank fails to exercise its option, but continues to pay the big coupons, while interest rates remain the same or fall. The buyer and seller can't both score big, ex post. However, ex ante, they may both think they're coming out ahead, based on rational considerations, such as intricasies of tax laws, perhaps in different countries ("tax arbitrage"), transactions costs, and attitudes towards risk. However, the transaction can proceed, even if they reach their conclusions based on complete misunderstanding of what they're giving and/or getting. – Dr. Risk Enter the Dragonfly (5/2898)Question:Dear Dr. Risk – Is "Dragonfly" trade good way to profit from Japanese problems with "millenium bug" as SIMEX says? – Hideo Tanaka Answer: Dear Mr. Tanaka – Frederick W. Sturm ("The Euroyen Millenium Dragonfly," Market Link no. 60, 02/98) defines the Millenium Dragonfly as short one each of the DEC 99 and MAR 00 Euroyen futures contracts, and long one each of the SEP 99 and JUN 00 Euroyen futures. The Japanese fiscal year ends on the last business day in March. Hence, the idea behind this trade is that the Millenium Bug will hurt Japanese financial institututions and affect Japanese markets at the ends of the calendar and fiscal years. Before I opine on the effectiveness of this trade, let me explain it more. In options, the long Butterfly Spread consists of a portfolio of four options that are identical, except for different strike prices: long one each of the options with low and high strikes, and short two units of the option with a strike smack in the middle. In other words, it is long a bull spread at low strikes and short a bull spread at higher strikes. The Butterfly Spread pays off when the underlying price ends up between the extreme strike levels, and pays off the most when it ends up at the middle strike. The long Condor is similar to the Butterfly, except that the strikes on the four options are at four different levels and the trader is long the extreme strikes and short the intermediate strikes. The Condor has a maximum payoff over the range between the two intermediate strikes. In bond trading a long Butterfly Trade consists of a portfolio of bonds with three different maturities: long one unit each of the short and long maturities, and short two units of the intermediate maturity. In other words, it is long a time spread with shorter maturities and short a time spread with longer maturities. In its purest form, with bonds of the same coupon rate, and all maturities on successive coupon dates for the longest bond, the Butterfly Trade creates a forward loan, equivalent to an FRA. A Butterfly Trade in futures trading is superficially similar to one in bond trading, with delivery dates replacing maturities. However, each futures contract creates something akin to an FRA, and the long Butterfly Trade creates a portfolio of FRAs that profits from increased curvature up in the middle of the forward curve. The Millenium Dragonfly is like a Butterfly Trade in futures,
but more of a "Condor". It profits when the forward
rates for December 1999 to June 2000 rise, relative to the rates
for September to December 1999 and June to September 2000. The
idea is that I can imagine that #1 is true. However, #2 requires smart people with lots of money to be a lot slower on the uptake than I can believe. So, don't count on me to back you up, if you "enter the Dragonfly". – Dr. Risk "Arbitrage" in the Real World #2 (4/30/98)Question:Dear Dr. Risk – i have read your answer to goldman (" 'Arbitrage' in the Real World," 11/29/97). you wrote the future price will be less than the forward price if there is a positive correlation between the values at the delivery date of the underlyling spot and the balance in the money market account. is it also possible to say: when the price of the share is positively correlated with interest rates, future price will be higher than forward price? – Mark Silverman Answer: Dear Mr. Silverman – What to Do When the Wolf Comes to Grandma's House (1/1/98)Question: Dear Dr. Risk – My mother's in her 80s and facing her mortality with amazing grace. She's giving $100,000 to each of her kids to beat the tax man. I'm trying to figure out what to do with mine. I was going to put it in an index fund, but my broker has recommended a fund that uses active management. What is it? What do you think of it? – Fifth of Seven Answer: Dear Fifth – Congratulations on your financial windfall, and thanks for writing. Let me answer in two parts. I. Before I answer your question about active management, let me give you a wake-up call concerning tax issues. Three points.
II. Active management is investment management with the aim of beating the market, rather than merely matching its performance. It sounds like a great idea. Who wants to give his money to an indexer or passive manager who admits right up front that he hasn't a clue about beating the market? Isn't it better to give your money to a professional who actively manages his fund to beat the market by one or two percent a year on a risk-adjusted basis? To answer a couple of questions with a couple of questions, let's put it this way: Would you prefer to ride with a taxi driver who goes with the flow or one who rushes through Christmas traffic, pushing cars and buses aside by telekinesis? Would you rather pay a regular airline for a ticket to your next vacation destination, or would you rather pay half price for a ticket from a college professor who promised to deassemble your body, molecule by molecule, convert your matter into energy, beam that energy to your destination, then reassemble your body? I hope you answered those rhetorical questions the way I anticipated – namely, I hope you prefer to base your decisions on a scientific model of reality, rather than on magic or wishful thinking. The Efficient Market Theory is that investors, including investment mangers, should find it impossible to consistently beat the market, because they can't count on doing it with publicly available information, and they can't consistently come up with private information. The academic literature supports this theory, except for relatively few anomalies. Every year the latest market data provide fresh support for this proposition. For example:
Without specific information to change my mind, I'll always favor the index fund with low management costs and honest managers. – Dr. Risk "Arbitrage" in the Real World (11/29/97)Question:Dear Dr. Risk – I hear you got your degree from Chicago and believe in efficient markets. In my experience, in the real world, nothing's that perfect. Lots of times I've seen cases where the futures price is consistently below the forward price. That means I can sell in the forward market and hedge out my risk by going long futures. At delivery I make the spread of forward over futures. I do that every chance I get, and my bank account is growing. How do you reconcile those facts with efficient markets? – Mark Goldman Answer: Dear Mr. Goldman – I love to get letters like yours from Wall Street "arbitrageurs", because I love to play "Where's the Risk?" I learned to play the game while I was earning my Ph.D. in the Economics Department at and studying in the Graduate School of Business of – you guessed it – the University of Chicago. In your case, let's focus on a crucial difference between forward and futures contracts, namely, variation margin. When you go short in the forward market, you commit yourself until delivery and have no cash flow until then. When you are long in the futures market, your broker will compute your variation margin daily, proportional to the change in the futures price. If the futures market goes against you, then recovers by delivery, you will have a net loss that equals the accumulated interest on the variation margin. If the futures market goes way against you and recovers suddenly at the end, and interest rates hit the roof, this loss can be large. I guess this hasn't happened to you, yet. I hope it never does. Of course, if the futures market goes your way and interest rates hit the roof, you will clean up. In equilibrium, the futures price will be less than the forward price if and only if you have a negative [This is a correction from the original answer. – Ed.] correlation between the values at the delivery date of the underlying spot and the balance in the money market account. In practice the difference between forward and futures prices can be small, but swap desks commonly adjust the implied forwards from Eurodollar futures markets to account for the difference. Back in the 1980s I interviewed for a research job in an investment bank. The prospective boss had made partner by doing "arbitrage" between the cash bond and bond futures markets. I thought this was an opportunity to show my analytical skill by pointing out that arbitrage between those markets wasn't possible, strictly speaking. Strangely, I didn't get the job and the partner went on to make tens of millions of dollars. Go figure! The point is, you are not doing classic arbitrage, which involves putting up no money and taking no risk. You, sir, are speculating – like the partner I mentioned. I'm not saying it's bad, and I'm not saying it won't ever work. I'm saying that it won't always work. Good luck! – Dr. Risk Stop the Market ... I Want to Get Off (10/21/97)Question:Dear Dr. Risk – I want to be in the stock market, because of the potential for making money, but the market makes me nervous, because of the potential for losing money. My broker says that I can protect myself against being in the market during crashes and being out of the market during rallies, as well as paying too much or selling too cheap, by using stop and limit orders. Is that right? – Torn in Topeka Answer: Dear Torn – I would prefer to be a fly on the wall, listening to your broker explain his position. I don't want to put words in a broker's mouth, but I think I can give the required sales pitches – and critique's or rebuttals. Let's start with what you're trying to accomplish, define terms, then move into relevant applications, explanations, and critiques. I heard you express realistic concerns and some wishful thinking. You want good execution on your purchases and sales, which is something we always want, can sometimes influence, but can't always get. Also, you want to be long in a rising market and out of a falling market, which would require a crystal ball, which none of us has. The orders are tricky, and the precise way a market handles a given order can depend on the precise microstructure of the market (e.g., pit, monopolistic specialist, competing market makers).
So, how can you use these orders?
To sum things up, if you knew that the market was going to exhibit momentum or reversals, then you could make money many different ways, of which stop orders and limit orders provide only a few. However, you can't count on having that sort of knowledge. Without that knowledge, those orders may be just sophisticated ways to get into the sort of unanticipated trouble that markets are so good at providing. – Dr. Risk Why [Almost] Everybody Ought to Buy Derivatives, If ... (9/30/97)Question:Dear Dr. Risk – I won the New York State Lottery, recently – $3,000,000. Some company called me up and bought my winnings for cash up front. My brother-in-law says they saw me coming and didn't pay me enough. Then, over the summer, a penny stock broker told me about some new issues he had coming out. He said he wanted to develop a relationship with me, and I didn't want to do something stupid like give him a million dollars, so I bought bought $5,000 worth of a "hot new issue". It hasn't done so hot. My brother-in-law says this guy saw me coming and I paid too much. I'm tired of having my brother-in-law second guess me, and want to make the right investment. I heard at a cocktail part that it was possible to tailor an equity derivatives portfolio for me, to reflect my attitude toward risk and my view on the market. I can't understand how that works Can you explain? – Confused in New York Answer: Dear Confused – Sounds like you attend interesting cocktail parties. The idea of tailoring a portfolio of equity derivatives to your tastes and market views has a sound foundation in theory going back to Hayne Leland in the early 1980s. I'm not sure anyone has ever done the math and then done the trade, but here's how it would go. First, you make a lot of assumptions:
From these assumptions you can derive your optimal payoff function:
Getting the required information about your views and tastes is technically demanding. So is computing the optimal portfolio. Justifying the assumption that you maximize expected utility is not a slam dunk. The overall process would bore most customers to tears. I found this out the hard way when I presented it to customers a few years back. Not even multicolored slides made the presentation sizzle. Consequently, The Street's appetite for this sort of approach for selling derivatives is limited. However, the risk manager at one top firm uses a process like this – in reverse, and involving portfolio theory, rather than option theory – to deduce a trader's implied market view. Then he shows the trader the imiplied view and asks him if he really believes it. Sometimes, the trader is shocked. I haven't heard whether this analysis has actually driven trades. The bottom line: I think this approach is promising, but it's clearly not mainstream. I doubt that it would shut up your brother-in-law, but then, what would? – Dr. Risk A Big Catastrophe for a Man. A Small Catastrophe for Mankind. (8/31/97)Question:Dear Dr. Risk – I spent my life working as an applied probability theorist and did pretty good – even got on television a few times. I've saved about a million dollars for retirement, and my wife and I have bought a place not far from the Strip in Las Vegas. My broker has suggested that I put the rest in some Catastrophe Bonds that his firm's recommending to more sophisticated investors. The coupon's a lot more than Treasuries or even corporates pay in today's market. I was worried about the risk, but he told me that the new generation of catastrophe models is way beyond anything the insurance companies had in the past. Based on those models, the coupons are extremely generous. What do you say? – Jimmie Snider Answer: Dear Mr. Snider – The issue is too complex for this space, but I'll make a few points: For our purposes, a catastrophe is a major insured disaster, defined by cause, time, place, and magnitude. The two main categories of catastrophes are hurricanes and earthquakes, which always occur within bounds of time and space. A catastrophe is so large that an insurer cannot sufficiently diversify away related claims, internally, as it can easily with deaths by heart attack. As a result, a catastrophe can threaten the survival of a casualty company, several companies, or even the entire casualty insurance industry. A catastrophe can threaten the payments to policy holders, too, because an insolvent insurance company may not be able to pay its claims. For example, Hurricane Andrew caused catastrophic damage in South Florida and Louisiana in August 1992. It forced State Farm & Casualty's parent to inject capital to prevent ruin, wiped out twelve insurers, and left $400 million in unpaid claims. (David Stipp, "A New Way to Bet on Disasters," Fortune, 9/8/97.) In contrast, even the crash of a jumbo jet is a small event that causes hardly a blip in the profits of insurance. An insurance company may try to manage catastrophic risk several standard ways. It can rule out the risk, as is ordinarily the case with acts of war. However, that would amount to exiting the industry. It can place a ceiling on its exposure, say up to $100,000 per policy, but this doesn't help if all the policies result in claims simultaneously. It can reinsure its claims with companies in other regions of the U.S. or world. The insurance market at Lloyds of London is an avenue for this. However, potential catastrophes – such as "The Big One" in California – are large, even compared to the capital of the reinsurance industry. Thus, the casualty industry may need more capital reserves to back its policies, because if the entire industry doesn't bring enough capital to the table, it's not clear that people will want to play the game with them. How might the casualty industry get even more risk capital? They might issue more shares – i.e., raise equity capital. They could issue more ordinary debt. That magnifies the debt of the shareholders and places the bondholders at some risk – perhaps a lot. The could hedge catastrophic risk in the catastrophe futures market. (We'll address this topic another day.) They could sell Catastrophe Bonds to people outside the industry. Now what are the main implications of selling Catastrophe Bonds outside the industry? First, the good news: It brings in outside capital that solves the mismatch of risk capital and risk. Catastrophes, such as earthquakes and hurricanes are small, compared to world – or even U.S. – capital. Now, the bad news: This new capital comes from people without the expertise to judge either the odds against a catastrophe or the models used to compute these odds. The role of the catastrophe modeling is crucial. Outsiders won't come in unless they think it's safe. The Catastrophe modelers may give a measure of comfort to people who don't really know what's going on. Yet, one has to wonder if the models really get the odds right. More importantly, even if the odds are right, the downside is enormous. Investors in "cat bonds" are picking up nickels in front of a bulldozer. Are they the right people to do that, when professionals in the industry are walking away from that opportunity? Mr. Snider, with that background, let me ask you a question: Would you bet your life savings in a high stakes poker in a game, where you didn't know the rules or the odds? If you would, all I can say is "Good luck!" If not, then why would you put your life savings in a bond that will produce either a somewhat more comfortable retirement (with probability 0.95, maybe) or a personal financial disaster (with probability 0.05, maybe). In the words of Dirty Harry, "Do you feel lucky?" – Dr. Risk Next Move, Boca Raton? (7/8/97)Question:Dear Dr. Risk – My broker called me from Boca Raton, recently, to suggest a few ways that he could add value to our relationship. For one thing, he pointed out that my U.S. dollar money market account is earning a puny rate of interest. He suggests that I buy into a global money market account that buys and sells short-term, riskless paper of developed countries and converts the returns from foreign currencies into dollars. Because rates of interest are higher in some lands and exchange rates are relatively stable, these professional managers are making a killing – a premium of 2% over the USD rates for the last six months. Should I switch? – Tom Next Answer: Dear Mr. Next – You should definitely switch – brokers – unless you're not telling Dr. Risk the whole story. We doubt that your broker's acting in your best interest. The product your broker is offering is an old product, a spread trade consisting of a long position in currencies earning a high rate of interest and a short position in currencies earning a low rate of interest. For example, in the 1960s Dr. Risk saw adds soliciting deposits in Mexican, peso-denominated bank accounts earning twelve percent when dollars rates were about half that. In the early 1990s a major commercial bank was offering a fund doing such trades. Before the ERM crisis a number of global money-market mutual funds offered such a product. This sort of global money market account may or may not earn you more than a dollar account. You'll be taking a gamble in what is probably a fair game for a retail customer. Even if the odds are in your favor, you will be taking substantial risk. However, you can be sure that your broker will earn more, with no risk. That's why he called you. A "value added product" is a euphemism for a non generic product with a higher commission rate. If he takes more out of the deal than your expected improvement in investment performance (i.e., close to zero), that leaves less for you. Dr. Risk suspects this is the case we are considering. Most troubling is not the possible currency devaluation, but not hearing anything about it. Did you just forget what he told you about that, or did he say nothing. What good does it do to earn twenty percent per annum (for sake of illustration) in pesos or baht if the peso or baht loses twenty percent of its value in three months? If your broker isn't aware that devaluation could occur, then he is incompetent. If he is aware, but doesn't tell you, then he is irresponsible. Either way, you can do better. – Dr. Risk When "Arbitrageurs" Weep (6/15/97)Question:Dear Dr. Risk – A securities salesman who doesn't ordinarily call on me suggested that I look at the B-Pieces of an ABS deal that he was underwriting. Ultimately, I passed. Despite the significant risks, which the salesman readily acknowledged, the deal was attractive. Did I make a mistake? – Tommy V. Answer: Dear Tommy V. – You did the right thing for two reasons. First, at their best, B-Pieces are for the more sophisticated and bolder investors, who are willing to do their homework and who play the game regularly. Dr. Risk doesn't know about your sophisticaion and boldness, and you get homework points for contacting Dr. Risk, but before you get into the game you should look closely at and pass up a few deals. These deals are like subways – wait five minutes and another one will come down the same track. Second, the B-Pieces you got to see were not the best. The only evidence Dr. Risk needs for that is that a salesman showed this deal to someone besides his regular customers. If the salesman could make a persuasive case that it was a terrific deal, the customers that had made his bonus possible would have seen it, and you wouldn't have seen it. Also, you can be sure that his firm's proprietary traders had no interest in it. So, why did you see it? Sometimes, when an underwriter brings out a two-piece ABS deal, the A-piece flies off the shelf like canned goods in Miami, just before a hurricane hits. The B-piece sells like a ham and cheese sandwich in a kosher neighborhood. This has happened enough recently to attract attention from the SEC and The Wall Street Journal ("SEC Is Examining Whether Some Underwriters Are Marketing Bonds at Artificially Low Yields", 5/2/97). Why don't the B-Pieces sell out? The asking price was too high. The SEC is trying to figure out why. Some people think it is a strategic marketing decision to keep underwriting business. Maybe, although it's hard to see the argument for that: Lose one percent on each deal, but make it up in volume? Dr. Risk thinks that this problem reflects a miscalculation or bad luck in a market with small spreads. Who are the "arbitrageurs", and why are they weeping? The issuer and the underwriter are the "arbitrageurs", and only the underwriters are weeping . The entire argument for a two-piece deal is arbitrage: take an income stream worth $98, slice it into two streams worth $85 and $15, and split the $2 difference between the issuer and the underwriter. The underwriters have guaranteed that this will happen. Since the issuer bought into the hypothetical $98, whether it was realistic or a low-ball, and receives the real $99, the issuer's hypothetical arb works. The underwriter is trying to do the real arb, paying $99 for something that it will slice up and sell in pieces for $100. If it can't do that right away, it isn't doing an arb. It's speculating, and that's reason for an underwriter to cry. – Dr. Risk Christmas Comes Early for Bankers and Brokers (5/14/97)Question:Dear Dr. Risk – An OTC option dealer has offered me a Costless Collar. I won't have to pay anything for it. What do you think about that as an investment strategy? – Virginia Answer: Dear Virginia, I hate to be the one to break the news to you, but there is no Santa Claus. Dr. Risk stopped believing in Santa Claus and the Tooth Fairy as a young child. He hopes that you will follow promptly in his footsteps. Nor do brokers perform their vital roles for free. As a young adult, preparing to travel abroad, Dr. Risk learned the expensive way that "commissionless trading" in currency could be more expensive than paying a commission. Similarly, "commissionless" stock trading can be more expensive than paying a commission. Currency and stock brokers must charge for their services, in order to survive. Consequently, they do charge. If they don't charge a commission, they get revenue from some other source. Currency brokers may act as dealers and take a bid-ask spread. Stock brokers sometimes sell order flow to firms who can profit directly from the inevitable bid-ask spread. Nor do OTC Derivatives Dealers work for free. Buying a "Costless Collar" is similar to engaging in commissionless trading, because the dealer makes his profit from the bid-ask spread. In some cases, the "Costless Collar" can be an extremely expensive proposition. For example, hypothetically, if a customer who owned a long cash equity position were extremely naive, he might sell an ATM Call Option to finance an OTM Put Option for downside protection. This position would cost nothing, guarantee zero profit, and open the door for a small loss. We might call this a "Zero Gain Collar". Of course, the customer is always right, so who am I to talk if he wants to buy a Costless Collar. However, if the customer wants to discover the hidden cost, he should shop around, get bid and offer quotes on the Call and the Put, and do the math to see the Collar's cost. One presumes that he buys option A at the offer and sells option B at the (equal) bid. The cost is option B's offer, less option A's bid – or half that, depending on how you look at it. – Dr. Risk A Stock Market CD (4/14/97)"This deal sounds so good, like I can't lose," my client said. "If I hadn't talked to you, I would have given them money right away. Now, I know enough to be suspicious, but I don't see the catch. What is it?" She handed me a letter offering a "stock market CD." 1. The ContractDr. Risk likes to begin his analysis of any product or deal with the contract that defines it. First, he has to admit to his share of pointless discussions where the two sides were assuming completely different structures. Second, while Dr. Risk isn't a lawyer, he appreciates the importance of each word and punctuation mark in a contract. An OTC Derivatives contract typically take the form of a Confirmation that incorporates ISDA documents. Unfortunately, my client didn't have any sort of contract, just a vague (at best) "offering letter" that the Bank had sent. The letter was advertising literature. It began with the bait, in the form of a false dilemma. "Every time you invest your money, you are making a choice that can affect your financial future. ... Should you invest in a Bank CD with the guaranteed safety of FDIC insurance? Or should you look for a stock market investment that ... could potentially pay you a higher return?" Then, the hook. "[W]e believe it's possible to have them both. In fact, that's why we're writing to you today." Okay! Sounds almost too good to be true. How do they do it? The letter wouldn't tell you – unless you were a mind reader. The letter was a kind of a Rorschach test. What you saw in it told more about you than about the product. Reading the letter to understand the product was about as useful as reading tea leaves to understand the future. "The term of the account is one year." Actually, the bank would tie up your money for one year plus anywhere from ten days to just over two months. You would pay for the CD anywhere from December 2, 1996 to January 24, 1997. During that period, you would earn a regular savings deposit rate. Then, from my reading of the letter, for ten days you would earn nothing. (As it turns out, that is not the case.) The CD would earn its equity return for one year, from February 3, 1997, to February 3, 1998. What would be the CD rate? I thought I knew, based on past experience. Many banks had offered this sort of Equity-Linked CD over the past few years. I thought the payoff would be principal, plus the payoff for an Average Price Call Option. At first, the letter seemed to confirm my hunch: "Each month we'll track the change in the S&P 500 Index. Then, at maturity, we'll average together those monthly Index levels for the entire year." I know many ways to average the monthly levels. However, the most obvious way is the simple, arithmetic average – i.e., add up the monthly levels and divide the total by twelve: A = (S&P1 + S&P2 + ... + S&P12) / 12. I thought that the CD rate would be Max(0,A-S&P0) / S&P0, probably. However, the letter was ambiguous on the precise payoff, and I thought it was contradictory. The more I read, the more confused I was. The next paragraph began, "If the Index has increased since the first day of your term, ..." That sounded weird. I think the most logical meaning of those words is "if the S&P at the end of the twelfth month exceeds its initial level, ..." However, the S&P could be up and the Average could be down, or the S&P could be down and the Average could be up. I began to entertain the idea that they were offering some sort of complex, exotic option that depended on the S&P's terminal value, as well as the average of month-end values. However, the typical product of this sort would be consistent with the words, "if the Average is greater than the initial Index level, ..." The sentence continued, "... you'll earn interest that is equal to the average monthly rate of growth." Things were looking complicated, indeed. Now, they say they're basing the CD rate on an average of monthly rates of growth. The obvious meaning of the words would be something like AR = (R1 + R2 + ... + R12) / 12, where R1 = (S&P1 - S&P0) / S&P0, etc. Then, the CD rate would be something like R=Max(0,AR). However, I would bet that no bank would offer this sort of exotic payoff, which would be difficult to replicate, hence hedge. "And if the market hasn't increased (or even if it has fallen), you won't lose a penny ... because 100% of your principal will be returned - and is guaranteed by the FDIC!" Wow! Heads, I win - tails, I don't lose a penny. Sign me up! Less facetiously, this sounded like boob bait for bubbas. I wonder if the Bank has never heard of opportunity cost – or simply thinks that their retail customers haven't. That is, apparently, they don't think a retail customer would ever compare the future value of the cost of buying the Stock CD's return to the return on an ordinary, fixed-rate CD. Further on, they write, on February 3, 1998, "we'll calculate the average monthly change in the S&P 500 Index since the term began." Now, are they going to base the CD rate on [(S&P12 - S&P0) / 12 = (S&P1 - S&P0 + S&P2 - S&P1 + ... + S&P12 - S&P11)] / 12 ? This could lead to a CD rate that was proportional to an ordinary option payoff: R = Max[0, (S&P12 - S&P0)] / (12 * S&P0). "And unlike most mutual funds, there are no sales charges or management fees." The most generous way to describe this statement is "disingenuous". The Bank incurs costs for selling and managing this product. Is it not charging enough to cover those costs? I think we can be pretty sure it isn't passing these costs on to its innocent, unsuspecting shareholders. If they don't include direct sales charges or management fees, then they include them indirectly, via a markup over the cost of producing the CD. The claim to do otherwise reminded me of banks that offer travelers foreign currencies with "no commission," but skin them with larger bid-offer spreads than some other banks that charge commissions. Clearly, the Bank's letter didn't describe its product sufficiently clearly to allow me to analyze it. I decided to call its "800" number for more information, and was soon speaking with a "Financial Adviser" – a Registered Representative and Insurance Agent. I said that the product sounded intriguing, but I couldn't figure out what it was, with all the contradictions in the sales literature. "Such as what?" she asked. I told her. She replied, "I was a math major. I see what you mean." I asked, "Can I see the contract?" I hoped it would be more definitive. She said she would send me more information. The "Terms & Charges Disclosure" arrived a few days later. The Bank's difficulty in communicating its product continued. The "hypothetical example," designed to clarify the computation of its CD rate, contained erroneous numbers. The index values averaged 536.67, but the text said they averaged 540 for an 8% CD rate. Nevertheless, I noticed a few more significant facts. Most significantly, the Bank did not guarantee that it would ever actually sell the CD, and did not define the circumstances under which it would withhold. "[The Bank] reserves the right to suspend or discontinue the availability of the [Bank] Market CD Account at any time without notice." 2. CommentEffectiveness of PresentationI measure the effectiveness of a sales presentation by how quickly I can get the information I need to decide whether to buy or not. I give the Bank's letter an "F", because it provides incomplete, inaccurate, and misleading information. I give the registered rep a "C", because she provided incomplete, accurate information. I realize her job is not to talk me out of a sale, but I prefer it when a salesperson discloses all the relevant facts. I give the Bank's "Terms & Charges Disclosure" a gentleman's "C". It appears definitive and relatively clear. Its flawed illustration is not actually misleading, just potentially confusing to anyone who actually tries to understand it. It disclosed the issuer's escape clause that killed my interest in the deal. Suitability of the ProductIt's hard to see why a retail customer would would be a natural buyer for an APO. The typical retail customer will not know what it is, won't have software to price it or the inputs for the software, and won't have access to comparative market price information. Also, it's hard to see why anybody would want to enter into a contract containing an escape clause that guarantees that the customer will pay too much for the product. PricingAnyone can price the Bank's Stock Market CD two main ways. The easy way, and the way the Bank's retail commercial banking department will probably do it is to ask an equity option desk or for a quote at the beginning of the accrual period. The more difficult way, which the desk will use is to run the required inputs through an appropriate APO pricing model. (By the way, the last I heard, the Bank's parent bank – a major bank, with global operations – had an expert in pricing this sort of option on staff.)
ConclusionI advised my client, "If you have, say, $100,000 to invest, then you can do better than this product. The contract's escape means you'd be on the losing side of an arbitrage, buying into a "heads I lose, tails you win" deal. If you want a guarantee of principal, plus some sort of optional equity exposure, consider investing most of your money in a regular CD and buying a LEAPS or S&P 500 Futures Option with the rest. The bid-offer spread is likely to be smaller than the Bank will offer you, and you can avoid giving the Bank the free option at the start of the CD's accrual period. If you don't have enough money to make it worthwhile to do this on your own, shop around a little in the retail market. Some retailer might give you a break. Just don't count on it." – Dr. Risk VaR Derivatives (11/14/96)I heard about these potential products first from the
following article: Liu, Ralph Yiehmin. "Learning Curve(R);
VaR Derivatives." Derivatives Week. September 9,
1996.
The Natural Buyer and Seller and Motivation.
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