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Abstract:
Several studies have reported how new credit risk transfer vehicles have made it easier to reallocate large amounts of credit risk from the financial sector to the non-financial sector of the capital markets. In this article, we describe one of these new credit risk transfer vehicles, the collateralized debt obligation. Synthetic credit debt obligations utilize credit default swaps, another relatively new credit risk transfer vehicle.

Financial institutions face five major risks: credit, interest rate, price, currency, and liquidity. The development of the derivatives markets prior to 1990 provided financial institutions with efficient vehicles for the transfer of interest rate, price, and currency risks, as well as enhancing the liquidity of the underlying assets. However, it is only in recent years that the market for the efficient transfer of credit risk has developed. Credit risk is the risk that a debt instrument will decline in value as a result of the borrower's inability (real or perceived) to satisfy the contractual terms of its borrowing arrangement. In the case of corporate debt obligations, credit risk encompasses default, credit spread, and rating downgrade risks.

The most obvious way for a financial institution to transfer the credit risk of a loan it has originated is to sell it to another party. Loan covenants typically require that the obligor be informed of the sale. The drawback of a sale in the case of corporate loans is the potential impairment of the originating financial institution's relationship with the obligor of the loan sold. Syndicated loans overcome the drawback of an outright sale because banks in the syndicate may sell their loan shares in the secondary market. The sale may be through an assignment or through participation. While the former mechanism for a syndicated loan requires the approval of the obligor, the latter does not since the payments are merely passed through to the purchaser and therefore the obligor need not know about the sale.

Another form of credit risk transfer (CRT) vehicle developed in the 1980s is securitization [Fabozzi and Kothari (2007)]. In a securitization, a financial institution that originates loans pools them and sells them to a special purpose entity (SPE). The SPE obtains funds to acquire the pool of loans by issuing securities. Payment of interest and principal on the securities issued by the SPE is obtained from the cash flow of the pool of loans. While the financial institution employing securitization retains some of the credit risk associated with the pool of loans, the majority of the credit risk is transferred to the holders of the securities issued by the SPE.

Two recent developments for transferring credit risk are credit derivatives and collateralized debt obligations (CDOs). For financial institutions, credit derivatives allow the transfer of credit risk to another party without the sale of the loan. A CDO is an application of the securitization technology. With the development of the credit derivatives market, CDOs can be created without the actual sale of a pool of loans to an SPE using credit derivatives. CDOs created using credit derivatives are referred to as synthetic CDOs.

In this article, we discuss CDOs. We begin with the basics of CDOs and then discuss synthetic CDOs. The issues for regulators and supervisors of capital markets with respect to CDOs, as well as credit derivatives, are also discussed.

Credit Risk, Capital Markets, Collateralized Debt, Liquidity Assets

Abstract:
Securitization as a financial instrument has had an extremely significant impact on the world's financial system. First, by integrating capital markets and the uses of resources - such as mortgage originators, finance companies, governments, etc. - it has strengthened the trend towards disintermediation. Having been able to mitigate agency costs, it has made lending more efficient; evidence of this can be observed in the mortgage markets. By permitting firms to originate and hold assets off the balance sheet, it has generated much higher levels of leverage and, though arguably, greater economies of scale. Combination of securitization techniques with credit derivatives and risk transfer devices continues to develop innovative methods of transforming risk into a commodity and allow various market participants to tap into sectors which were otherwise not open to them.

In its broadest sense, the term "securitization" implies a process by which a financial relationship is converted into a transaction. A financial transaction is the coming together of two or more entities; a financial relationship is their staying together. For example, a loan to a corporation is a financial relationship; once the loan is transformed into a tradable bond, it is a transaction. We find several examples in the history of the evolution of finance of relationships that have been converted into transactions. The creation of "stock," representing ownership in a corporation, is one of the earliest and most important examples of this process because of its impact on the growth of the corporate form of business organization. The process of converting loans to corporations of high credit quality corporate borrowers, and in the 1970s expanding that opportunity to speculative-grade corporate borrowers, into publicly traded bonds is another example of this. Commercial paper is another example of securitization of relationships as it securitizes a trade debt.

Integrating Capital Markets, Mortgages, Leverage, Financial Transformations

Abstract:
This study provides new evidence on the market impact of new issues of convertible bonds of U.S. listed firms. We examine on the market reaction surrounding the announcement dates and the issue dates of convertible bonds. The evidence suggests that firms experience negative abnormal returns around the announcement of new issues of convertible bonds. Abnormal returns are found to be a function of firm market value, price-to-book ratio, issue size, as well as the state of the overall market. Simulations using convertible arbitrage strategies suggests that investors could take advantage of these negative abnormal returns by going long on the firm's convertible bond and short on the firm's stock at the issue date.

Abstract:
There are many conflicting interpretations of security prices and price determination in financial markets. They range from academic theories based on efficient markets and rational expectations hypotheses, to more traditional methods of fundamental analysis, to theories of "value" and "growth" investing, to chart-reading and technical analysis, to notions such as "reflexivity." These interpretations are logically inconsistent with each other, but they seem to co-exist, sometimes even on the same trading desk. In this paper, we seek to formulate an explanation for this strange coexistence, using some tools from critical theory to understand how financial markets operate. Structuralism is used to analyze various kinds of narratives appearing in the financial literature, which are intended to have explanatory force, and appearance of sometimes contradictory elements in such narratives; post-structuralism is used to explain the way in which contradictory interpretations co-exist. We discuss some practical implications for security valuation, option valuation, trading strategies, market risk management, and volatility estimation.

Abstract:
In this paper, we empirically investigate two economic issues (1) the factors that affect the primary market spread on non-U.S. asset-backed securities and (2) whether investors rely solely on credit ratings and ignore other credit-related factors. We do so by using a panel-data fixed-effects model of primary market spreads for tranches of non-mortgage-related asset-backed securities issued over the period 1999-2006. With respect to the determinants of the primary market spread, we find that spread can be explained in terms of two factors credit rating and bond market conditions. Our tests support the hypothesis that despite heavy reliance on credit ratings, investors do consider factors that the rating agencies state that they consider in assigning ratings. Hence, there is reason to suspect that the notion of pure reliance on assigned ratings that has been popularized in the market may be overstated.

asset-backed securities (ABS), credit ratings, collateral, default risk, securitization, securitisation

Abstract:
Although property markets represent a large proportion of total wealth in developed countries, the real-estate derivatives markets are still lagging behind in volume of trading and liquidity. Over the last few years there has been increased activity in developing derivative instruments that can be utilised by asset managers. In this paper, we discuss the problems encountered when using property derivatives for managing European real-estate risk. We also consider a special class of structured interest rate swaps that have embedded real-estate risk and propose a more efficient way to tailor these swaps.

real-estate markets, property derivatives, balance guaranteed swaps

Abstract:
Despite portfolio construction based on expected utility theory and Markowitz mean-variance optimization having been the foundation of financial economic theory for more than 50 years, its practical application by financial advisors has been limited. Particularly troubling are the lack of a normative risk-aversion parameter customized to individual investor circumstances and the need for extensive constraints to produce practically acceptable results. We propose a comprehensive conceptual framework for better investment policy. To begin, we develop investor circumstance-contingent risk aversion for use in portfolio construction, taking into account higher moments of return only as needed. We recursively maximize expected logarithmic return on what we define as "discretionary wealth" to generate many-period maximization of median wealth without violating interim shortfall points. Then we extend this basic framework based on point estimates to fully Bayesian logic. This offers not only improved decision inputs but the advantage of deriving the probability distribution of the objective as a function of portfolio weights before selecting the best portfolio. Implications are discussed for a wide array of practical issues: investor leverage, longevity risk, higher return moments, dynamic hedging, life-cycle investing, performance measures, and robust portfolio construction. Hypotheses for implied market structure and pricing are also generated.

investment policy, discretionary wealth, Markowitz optimization, higher moments, implied leverage, Bayesian investing, robust optimization

Abstract:
In this paper we derive closed-form solutions for the cumulative density function and the average value-at-risk for five subclasses of the infinitely divisible distributions: classical tempered stable distribution, Kim-Rachev distribution, modified tempered stable distribution, normal tempered stable distribution, and rapidly decreasing tempered stable distribution. We present empirical evidence using the daily performance of the S&P 500 for the period January 2, 1997 through December 29, 2006.

tempered stable distribution, infinitely divisible distribution, value-at-risk, conditional value-at-risk, average value-at-risk

Abstract:
In the study of asset returns, the preponderance of empirical evidence finds that return distributions are not normally distributed. Despite this evidence, non-normal multivariate modelling of asset returns does not appear to play an important role in asset management or risk management because of the complexity of estimating multivariate non-normal distributions from market return data. In this paper, we present a new subclass of generalized elliptical distributions for asset returns that is sufficiently user friendly, so that it can be utilized by asset managers and risk managers for modelling multivariate non-normal distributions of asset returns. For the distribution we present, which we call the multi-tail generalized elliptical distribution, we (1) derive the densities using results of the theory of generalized elliptical distributions and (2) introduce a function, which we label the tail function, to describe their tail behaviour. We test the model on German stock returns and find that (1) the multi-tail model introduced in the paper significantly outperforms the classical elliptical model and (2) the hypothesis of homogeneous tail behaviour can be rejected.

Abstract:
A new approach for using Lévy processes to compute value-at-risk (VaR) using high-frequency data is presented in this paper. The approach is a parametric model using an ARMA(1,1)-GARCH(1,1) model where the tail events are modelled using fractional Lévy stable noise and Lévy stable distribution. Using high-frequency data for the German DAX Index, the VaR estimates from this approach are compared to those of a standard nonparametric estimation method that captures the empirical distribution function, and with models where tail events are modelled using Gaussian distribution and fractional Gaussian noise. The results suggest that the proposed parametric approach yields superior predictive performance.

Abstract:
Resemblance in portfolio composition of sheltered and unsheltered equity funds held by open-end U.S. investment companies is consistent with their practice of identifying sheltered vs. unsheltered claims on the same portfolios instead of segregating portfolios based on shareholders' tax treatment. This paper questions the consistency of this policy with the objective of maximizing tax-sheltered return and value. If, as evidence suggests, the market is dominated by tax-paying individual investors, risk-adjusted rates of return would approach uniformity after tax, but not before tax. To the extent that capital gains are taxed at preferential effective rates, uniform posttax returns imply higher risk-adjusted pretax returns of those stocks in which a greater proportion of the return is paid in dividends. Elton and Gruber (JFE 1978) derive the optimal portfolio of an investor who is in a tax bracket different from that dominating the market, but without reference to the CAPM. That framework is not relevant for large investors, like mutual funds, holding highly diversified portfolios. Brennan (NTJ 1979) extends the CAPM to an environment of personal taxes, but does not investigate the implications for individual investors who are tax sheltered. We provide a correct, practical method for constructing an optimal stock portfolio that is tailored for the tax-sheltered fund operating in the environment of preferential tax treatment of capital gains. In such an environment, the performance of a sheltered equity fund may be substantially enhanced by a segregated portfolio with composition that differs from that which is optimal for an unsheltered fund.

tax-sheltered equity portfolio, tax-sheltered diversification, open-end investment fund

Abstract:
Roll [JFE 1977] demonstrates that the probability of early exercise of equity call options is low for small dividend payouts. Geske and Shastri [JBF 1985] show that unless dividends are small, put equity options would not be exercised early. Subsequently, Shastri and Tandon [JFM 1986] argue that the probability of early exercise of foreign currency options is small since foreign interest rates are analogous to a continuous dividend payout. Based on this observation, they conclude that a European model is well-suited for pricing American foreign currency options, unless the foreign interest rate is unusually high/low for call/put options. This conclusion is supported by the observation that pricing errors of a European option model are insignificant. Our study compares the Barone-Adesi-Whaley [BA-W; JF 1987] American option-pricing model with the Garman-Kohihagen [JIMF 1983] and Grabbe [JIMF 1983] European model and tests the conditions under which foreign exchange options convey opportunities to profit from premature exercise. Our results demonstrate the following. (1) The BA-W model is only advantageous in pricing out-of-the-money, long-term options. (2) The probability of gainful early exercise of puts is more sensitive than that of calls to the interest rate differential, time to maturity, and volatility. (3) The critical spot rate in the BA-W model is based on the probability of gainful early exercise on a given date, not after that date. Based on this criterion, we find a large number of opportunities for early exercise among in-the-money options maturing in less than 45 days.

foreign exchange option models, currency options, gainful early exercise, profit opportunities, exchange rate, international interest rates, international lending, trade financing

Abstract:
The Economic Recovery Tax Act of 1981 (ERTA) was designed to stimulate capital investment through liberalization of depreciation allowances and investment tax credit for property acquired and placed in service after December 31, 1980. To offer equal incentives to companies that could not benefit from these changes, the ERTA made it easier to sell those tax benefits. The vehicle created by Congress for selling the unused portion of tax benefits is known as the safe harbor lease. At the extreme, an unprofitable company can purchase and own an asset, while selling outright for cash the tax benefits typically associated with ownership. Under this arrangement, referred to as Tax-Benefit Transfer (TBT) lease, the firm buying the tax benefits is recognized as lessor and owner of the assets for tax purpose only. Although the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982 repealed safe harbor leases after December 31, 1983, the conferees included special transitional rules to allow safe harbor leasing beyond that date for certain troubled industries. This paper derives a valuation formula for pricing the TBT lease as viewed by the lessor. Further analysis examines the partial and joint effects on price of two decision variables - the interest rate charged on the attached phantom loan and the term of the lease - and contrasts the pricing model of the new type of lease with that of a conventional financial lease.

financial leases, lease valuation, corporate taxation

Abstract:
This theoretical paper seeks to correct a common error about the effect of personal taxation on the expected pre-tax return earned on equity portfolios held by mutual funds in tax-sheltered retirement plans such as IRA and Keogh (401-k). Contrary to the prevailing view, the analysis reveals that the pre-tax return on a stock is inversely related to its per-share growth rate. The explanation for this effect does not rely on the false assumption that growth decreases the effective rate of taxation. Rather, this effect holds despite the heavier taxation of growth stock - because of the incomplete manner in which the return is sheltered. This finding has important implications for the optimal equity portfolios held by tax-sheltered pension funds. Most immediately, this finding is inconsistent with the frequent practice of such funds of concentrating in growth stocks or recommending them to their clients. A second issue examined is the use of IRA and Keogh plans as a temporary tax shelter. Under the present penalty of 10 percent imposed on premature distributions, the minimum beneficial sheltering period may be as short as two-to-three years. This indicates the potential attraction of such plans as a general investment tool.

investment for retirement, pansion plan, tax-sheltered stock portfolio, growth vs. income stocks

Abstract:
Traditional static models of corporations' interior optimum leverage rely on institutional mechanisms such as taxes, bankruptcy costs, and agency costs. Theories of leverage indifference in the presence of risky debt depend on various features of perfect and complete markets and on the assumption that all investors hold a uniform portfolio. In the model developed here, corporate interior optimum leverage is obtained as a result of a fundamental risk-return trade-off for investors who hold non-uniform portfolios of risky equity and debt claims in the absence of market mechanisms that would force leverage indifference. The dynamic optimization solution accommodates bankruptcy costs and specialized institutional factors but does not rely on their presence.

optimal capital structure, static theory of capital structure

Abstract:
This paper challenges accepted methods of calculating the effect of deferred realization on the effective rate of capital gains tax paid by common shareholders and their overall tax burden. Those methods are shown to implicitly assume the special case of gains accrued in lump sum, even under the common scenario of gains accrued gradually over time. A widely-accepted method is also shown to overstate the effect of deferral by implicitly using the internal rate of return as a discount rate. The valuation-based method proposed here is especially useful for growth stocks where gains are accrued gradually and realized in lump sum. The same method is used to calculate the firm's cost of retained earnings under a finite deferral period. Depending on the tax and interest rates and the extent of deferment, the accuracy gained by using the proposed method can better inform shareholders, their firm's investment and distribution policies, and government tax policy.

See reply: National Tax Journal, Vol. 44, No. 1, March 1991.

growth stocks, shareholder effective capital gains tax, capital gains tax deferment, cost of capital, share valuation, payout policy

Abstract:
The importance of asset allocation policy in stock/bond portfolios is widely recognized. Drawing a parallel for equity-only portfolios, this study analyzed the importance of allocation by economic sector and by size and style in purely U.S. stock portfolios and the importance of regional allocation policy in international stock portfolios. The study found that allocation policy explains one-third to nearly three-quarters of among-fund variation in returns, nearly 90 percent of across-time variation, and more than 100 percent of the level of stock portfolio returns.

Portfolio Management: Asset Allocation, Equity Strategies

Abstract:
The largest sector of the U.S. investment-grade fixed-income market is structured products - mortgage-backed securities and asset-backed securities. Issues and challenges currently facing investors who participate in this market sector include legal issues (e.g., consumer lending legislation), market structure (e.g., the role of the government-sponsored enterprises), and analytical methods (e.g., prepayment modeling). An important current concern is the need for education and training in the structured products area - particularly for investment policy compliance staff and for equity analysts.

Debt investments, asset-backed securities (including mortgage-backed securities), bonds with embedded options, credit analysis, derivative instruments, debt derivatives