Towards a Better Policy: Analyzing Municipal Refundings Using a Real-World Market Model

43 Pages Posted: 9 May 2014

See all articles by Peter Orr

Peter Orr

Intuitive Analytics LLC

David de la Nuez

Intuitive Analytics LLC

Date Written: April 30, 2014

Abstract

In the $3.7 trillion municipal bond market, the timing of a refunding is an important decision: refund too early and the opportunity for greater budgetary benefit may be precluded; refund too late and an attractive rate market may never return. In this paper, we argue that reliance on simple heuristics or even arbitrage-free option models to derive a refunding policy is inappropriate, because hedging exposure to municipal securities is very hard or even impossible for issuers. Instead, we discover and propose a novel, robust municipal refunding policy that maximizes expected present value (EPV) savings under a real-world, history-consistent interest rate model following Deguillame et al (2013). The proposed policy dominates 30 other tested policies in simulation. This real option framework can be used both by issuers to maximize the expected value of their call options, and by investors, to value and manage risk in callable municipal bond holdings.

Keywords: Refunding, Municipal Bonds, Tax-exempt, Public Finance, Yield Curve, Options

Suggested Citation

Orr, Peter and de la Nuez, David, Towards a Better Policy: Analyzing Municipal Refundings Using a Real-World Market Model (April 30, 2014). Available at SSRN: https://ssrn.com/abstract=2431275 or http://dx.doi.org/10.2139/ssrn.2431275

Peter Orr (Contact Author)

Intuitive Analytics LLC ( email )

100 Park Ave
Suite 1600
New York, NY 10017
United States
646.202.9446 (Phone)

HOME PAGE: http://www.intuitive-analytics.com/

David De la Nuez

Intuitive Analytics LLC ( email )

100 Park Ave.
Suite 1600
New York, NY 10017
United States
646 202 9446 (Phone)

HOME PAGE: http://www.intuitive-analytics.com/

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