Early Redemption Research Articles

Evaluating corporate bonds with complicated liability structures and bond provisions

This paper presents a general and numerically accurate lattice methodology to price risky corporate bonds. It can handle complex default boundaries, discrete payments, various asset sales assumptions, and early redemption provisions for which closed-form solutions are unavailable. Furthermore, it can price a portfolio of bonds that accounts for their complex interaction, whereas traditional approaches can only price each bond individually or a small portfolio of highly simplistic bonds. Because of the generality and accuracy of our method, it is used to investigate how credit spreads are influenced by the bond provisions and the change in a firm’s liability structure due to bond repayments.

Volatility Exchange-Traded Notes: Curse or Cure?

This is the first comprehensive study of VIX futures ETNs. This empirical research into their statistical characteristics motivates the development of a sub-class of these notes based on static and dynamic differential roll-yield trades. Results show that such notes provide very attractive risk and return characteristics, plus a new source of diversification for non-speculative investors. Moreover, scenario analysis demonstrates that banks may control ETN issues so that profits are virtually guaranteed net of hedging costs. However, there is a dark side to ETNs currently in issue, which stems from a few sub-optimal terms and conditions concerning early redemption values. These conditions underpin: i) the speculative front-running of hedging activity, which has very negative consequences for issuers; ii) a moral hazard problem, which is induced by the one-day notice period for early redemption, and iii) large-scale spill-over activity to VIX futures trading, which is a potential new source of systemic risk. <b>TOPICS:</b>Exchange-traded funds and applications, futures and forward contracts, performance measurement

MUSHARAKAH MUTANAQISAH PARTNERSHIP IN MALAYSIA’S ISLAMIC BANK: A COMPARISON BETWEEN THEORY AND PRACTICE

Diminishing Musharakah Mutanaqisah Partnership (MMP) contract has been offered by Islamic banks in Malaysia, this study aims to presents the result of a comparison made between the theoretical explanations of how the MMP works and what is actually being done in practice. This study makes use of a qualitative approach in analysing how the MMP works in practice. It then makes a comparison between the MMP as being practiced in real situation and what theoretical writing tells us to expect by analysing an offer letter of a customer of HSBC Amanah Malaysia. Further research is carried out on home financing packages offered by 10 local Islamic banks and 6 foreign Islamic banks by calling the banks and walking into the branches. Our findings reveal that HSBC Amanah Malaysia is using base financing rate replacing the market rental rate of which the base financing rate is the same as base lending rate in the conventional housing loan. In addition, HSBC Amanah also imposes penalty charges on any early settlement and redemption. Other local and foreign banks are also using similar base financing rate to determine the rental rate and only a few of them are not imposing penalty charges on early settlement and redemption. This study provides result that HSBC Amanah’s Home Smart-i facility, the MMP in practice is moving towards a convergence to conventional banking and in fact, there is no difference with conventional housing loan. For HSBC Amanah to truly offer and reflect the principles and tenets behind MMP contracts, it has to make some amendments to the terms and conditions as stated in its offer letter for a diminishing musharakah mutanaqisah partnership contract.

Non-Callable Time Deposits in Light of Basel III and Polish Banking Law

Basel Committee proposal of liquidity measures (LCR&NSFR) contain quantification of risk of various deposit classes. According to Basel 3, there is no significant difference in stability between time deposits with early withdrawal option and demand deposits. Only deposits where there is no early redemption option (or, for retail, if withdrawal penalty is higher than interest) receive better regulatory weights. Such deposits, most stable in terms of systemic risk, cannot be introduced in Poland, because civil code and banking law regulations, their interpretations and related court rulings make them practically impossible. It is proposed that the regulations be adequately amended and the most stable class of deposits be supported by regulatory tools similar or identical to Basel 3 constructs.The Polish version of this paper can be found at: http://ssrn.com/abstract=2274108

Volatility Exchange-Traded Notes: Curse or Cure?

This paper investigates the trading, hedging and performance characteristics of VIX futures exchange-traded notes (ETNs) and discusses their pros and cons from the perspectives of the regulator, the issuer, and the non-speculative investor. Is this direct trading of volatility in very high volumes a major new source of issuer risk and systemic risk? Or – as advertised by the issuers – do these notes provide a unique source of diversification that should be welcomed by investors and regulators alike? To answer these questions we replicate the ETNs daily indicative values from March 2004 – March 2012, showing that the amplitude and frequency of volatility cycles have indeed increased markedly since the introduction of VIX futures ETNs. On the other hand, we explain how long-term investors can build simple ETN portfolios with uniquely attractive performance and diversification characteristics – provided they hold inverse rather than direct short-term tracker ETNs. Then we focus on the ETN issuers’ hedging activities, where the terms and conditions of early redemption provide transparent front-running opportunities for speculators which in turn increases both the hedging error and the volatility of VIX futures. Furthermore the one-day notice period for early redemption presents a moral hazard problem for the issuer.

Toxic Asset Subsidies and the Early Redemption of TALF Loans

This paper develops a formula to numerically estimate the unsubsidized, fair-market value of the toxic assets purchased with Federal Reserve loans. It finds that subsidy rates on these loans were on average 33.9 percent at origination. Yet, by the 3rd quarter of the 2010, there was on average no subsidy in TALF loans. The theoretical model is used to predict the early redemption of Term Asset-Backed Securities Loan Facility (TALF) loans used to purchase commercial mortgage backed securities (CMBS). The predictions of the model are strongly supported by the data. In addition, this paper looks at the determinants of early redemption. CMBS originated inside the peak bubble years of 2005-2007 were much less likely to be redeemed early. The giant investment managers, Blackrock and PIMCO, were much more likely to redeem their TALF loans early than smaller investment managers.

Toxic Asset Subsidies and the Early Redemption of TALF Loans

Toxic Asset Subsidies and the Early Redemption of TALF Loans

The Pricing of Derivatives When Underlying Paths are Truncated: The Case of Express Certificates in Germany

Express certificates form a new class of structured derivatives in Germany with dynamic growth in terms of market capitalization. They are subject to early redemption if the underlying is above strike levels at predetermined points in time. This early redemption leads to a truncation and conditioning of underlying paths and increases the complexity in the valuation of these products. Hence, no closed form pricing formulas exist to date. This paper develops a pricing formula for an efficient numeric pricing of express certificates using the truncated multivariate normal distribution and presents the main product characteristics and sensitivities.

Characterizing Yield Spreads in Bonds with Embedded Options

This is an examination of the wider yields posted by corporate debt instruments with embedded options compared to those of ordinary corporate debt issues. Apart from credit and liquidity risks, there are other risk components inherent in bonds with embedded options that make their yields much different from those of ordinary bonds. Notable among them would be the risk premium payable for the early redemption feature offered. Option adjusted spread analysis, which is an improvement over previous analytical methods yet with its own limitations, is lately used to perform bond yield analysis. Apparently the attempts made in this direction don't give enough attention to consider the effects of volatility spillover in order to model the spread between the issues with embedded options and those without any. This paper is an attempt to explain the behavior of yield spread in corporate bonds with embedded options taking the effects of volatility and market news into consideration. To take the effects of volatility spillover in the case of bonds with embedded options into consideration, GARCH-M and EGARCH models have been made use of for a total of ten bond pairs, the procedure for which has been illustrated in this paper.

Breaking New Boundaries

The innovative Essential Public Infrastructure Capital II (EPIC II) securitization will allow Depfa Bank, the originator and servicer for the transaction, to transfer the credit risk of a pool of PPP infrastructure loans, thereby providing regulatory capital relief, enhancing the bank9s return on equity, broadening the investor base for infrastructure financing paper, and further refining the template for future securitization of infrastructure loans. The EPIC II transaction, like its predecessor EPIC I, is structured as a synthetic, partially funded collateralized loan obligation (CLO). Credit strengths of the transaction include geographic diversity of the loan pool; the role of Kreditanstalt fur Wideraufbrau (KfW) as sponsor, collateral provider, and custodian; satisfactory project asset quality; an early redemption feature; and a structure that insulates investors from interest rate risk. Weaknesses include noteholders9 exposure to the default of reference loans if the first-loss piece is insufficient to cover such default, EPIC II9s ability to replenish the pool of assets in a way that would cause the weighted average credit quality to decrease, the credit risk of transportation assets in the reference pool – generally greater than the credit risk of traditional PPP availability-based projects, the limited source of cash flow for each underlying project, and uncertainty over the timing, costing, and life-cycle requirements for each project. Mitigating factors offsetting those weaknesses include rating agency credit estimates for unrated projects and the senior secured position of credit facilities in the capital structure of each project.

A Valuation Model for Callable Foreign Bonds

This paper models the value of callable foreign bonds, using stochastic calculus, by assuming that the exchange rate follows a geometric Brownian motion process and the arrival time of an early redemption of the bond by the issuer conforms to a negative exponential distribution. The solution to the stochastic model shows that there is a relationship between the call premium and the expected time to the call which is consistent with traditional Black-Scholes pricing formulae. The magnitude of the call premium can be viewed as a signal to the market on a Government treasury's or company's expectations about the future level of interest rates and possible refinancing strategies.

Dormancy risk and expected profits of consumer loans

A bank that lends money to a household faces two types of risk. Frequently mentioned is the risk of default. Seldom referred to is the risk of an early redemption of the loan – leading to dormancy. In this paper, we model the transition of consumer loans from an active to a dormant state. To this end, we use data on 4786 individuals who were granted credit by a Swedish lending institution between September 1993 and August 1995 and estimate a semi-parametric duration model. We analyze the factors that determine the time to maturity on consumer loans and investigate the ability of the model to match the maturities observed in the data. Moreover, we derive the distribution of conditional expected durations of loans and show how a loan application can be evaluated by calculating its expected profit.

Demandable Debts as a Means of Payment: Banknotes versus Checks

We examine whether transactable forms of privately issued, demandable debt are better used as or The distinction between the two is that a check must be redeemed by the issuing bank with each use whereas a banknote can circulate. We find that the answer to the question depends on the cost of early redemption. If this cost is small, banknotes will not circulate so the question is moot. If this cost is large, incentive problems may prevent the circulation of banknotes. For intermediate values of the early redemption cost, banknotes will be preferred over checks.

Que valent les options cachées ?

What are hidden options worth ? Advance redemption, loan right, power of redemption, possibility of extension, all this are examples of hidden options : a designation which may seem misleading. These options are not at all hidden ones, but they are part of a variety of banking and insurance products which we are analysing on the French market. Instead, they share some typical characteristics of options, even if the comparison with derivative products negotiated on the financial markets enables to distinguish some differences. The article shows that the evaluation of these options remains a difficult task to perform mainly because it requires the modelling of customer's behaviour. It is nevertheless necessary to take into account their value when billing services, as well as regards financial and balance-sheet management. In fact, their small « issue » value (some 0,3 % in the case of early redemption) hides strong potential variations. As all derivatives products, these options have a high gearing.

Market index depository liabilities: Analysis, interpretation, and performance

This paper examines a new financial instrument, the market index CD. This deposit offers an interest rate equal to a specified fraction of the change in the stock market over the life of the CD with a guaranteed minimum. We present a pricing formula, an examination of the effects of underlying variables, an evaluation of the early redemption feature, empirical results on the historical performance, and a discussion of some issues suggested by the introduction of this product.

Colonial Monetary Standards Contrasted: Evidence from the Seven Years' War

The Seven Years' War warrants a reinterpretation of the colonial paper-money experiment. Pennsylvania, New York, and South Carolina with fiduciary standards issued large quantities of paper money to finance the war accompanied by only moderate increases in the rate of inflation. Massachusetts with its pure specie standard financed the war with interest-bearing debt and fared little better, if not a little worse. Success of war finance in Pennsylvania, New York, and South Carolina can be attributed to paper-money issues that financed government expenditures and were matched by imposition of tax labilities for early redemption.

The Choice of Call Provision Terms: Evidence of the Existence of Agency Costs of Debt

ABSTRACTAn examination of the provisions of bond issues reveals that most bonds prohibit firms from calling the issue during the initial years, after which time the bond can be called at the option of the firm. A substantial number of firms, however, also reserve the right to call the issue during this initial period for purposes other than refinancing at a lower coupon rate. The additional flexibility which accompanies the option of early redemption can be used to reduce the agency costs of debt associated with future investment opportunities, informational asymmetry, and the risk incentive problem. Using a sample of newly issued bonds, statistical tests are performed to show that there are, in fact, differences between firms which do and do not reserve the right of early redemption. This paper shows that these differences provide empirical evidence which is consistent with the hypothesis that firms use the option of early redemption to reduce agency costs.

Immunization of Pension Funds and Sensitivity to Actuarial Assumptions: Comment

A recent article by Keintz and Stickney (K-S) [5] outlines a bond duration method for immunizing pension plans from market rate risk. The authors show how unexpected alterations in market rates of return can cause offsetting changes in pension assets and liabilities. By employing Macaulay's bond duration formula, K-S demonstrate how these opposing balance sheet changes may protect a pension plan from random market rate movements. Their research should prove quite useful in managing pension funds where the investment instruments have known maturities. Some pension plans, though, may desire to invest in corporate bonds where call features could alter maturity structure unexpectedly. K-S raise the issue of the effect corporate bonds with callable features could have on duration. The K-S technique relies to some extent on the pension manager matching the maturity structure of investment assets with fund liabilities.' A call provision allows the borrower to redeem bonds before maturity and thus may impose uncertainty on the length of the asset holding period. Many corporate bond issues will include call privileges which permit early redemption.2 Ostensibly the purpose of the call feature is to provide the corporation with the chance to refinance their bonds when interest rates are lower than when the bonds were originally issued. A bond call provision subjects the investor to the risk of redemption at a time of low interest, thus reducing overall investment yield and uncertainty as to when bond proceeds are payable. Most investors protect against this type of interest rate risk by requiring a higher yield on callable issues. However, the uncertainty with respect to maturity structure of callable issues is one over which the investor has little control. Figure 1 depicts the type of situation faced by the investor in callable securities. Condition A prevails as long as market interest rates during the call period are above the effective yield on the bond. Condition B necessitates