This potential trade was discussed in the comments to a post that posed the question: TCA.PR.X & TCA.PR.Y : What’s Keeping Them Up?.
So … just for fun, I created a portfolio which held two issues, TCA.PR.X and TCA.PR.Y, 1,000 shares of each. I defined the portfolio as trading according to the issueMethod, with a desired number of issues equal to 2.
I produced a number of reports, most of which will look like complete gobbledy-gook. You can start tracing their meanings with some help from the glossary:
- CU.PR.A – valuation at ask
- CU.PR.A – penalties
- TCA.PR.X – valuation at bid
- TCA.PR.X – penalties
- Trade Evaluation
- Pickup Calculation detail
- Risk Measurement detail
- Friction Calculation Detail (very boring in this instance)
So … the vital number is the trade score … “100” means the trade is recommended even at bid to full offer; “0” means the trade is recommended at full offer to bid (i.e., OK if you can sell at the offering price and buy at the bid price). In this case the trade score is -1,773 … the trade is so far away from being recommended we might just as well stay home.
Looking at the trade evaluation, though, we do see there’s a pretty good pickup; the trade is not recommended because the required pickup is enormous … ridiculously enormous, in fact. It would be very rare for a potential trade to meet such a hurdle.
Looking at the Risk Measurement report, we find that the required pickup is ridiculously big because the change in pseudoConvexityCost is ridiculously big.
The calculation of pseudoConvexityCost in HIMIPref™ is not something I’m very happy with. It will be changed in the next version of HIMIPref™, but I have to play with it. The problem is that in some conditions, the numbers are implausible and counter-intuitive … this is prevented from fooling the trade recommendation engine by various checks and catches in that part of the programme … but I still don’t like it.
Anyway, the derivation of the extremely high pseudoConvexityCost for TCA.PR.X can be traced (part of the way down the route) with:
- TCA.PR.X PseudoConvexity
- TCA.PR.X – pseudoModDur (base price)
- TCA.PR.X – pseudoModDur (high price)
- TCA.PR.X – pseudoModDur (low price)
- TCA.PR.X – costYield (base price)
- TCA.PR.X – costYield (high price)
- TCA.PR.X – costYield (very high price)
There’s more in the system. To understand costYield, you have to look at the cash flows, in which the embedded option is treated as a cash flow adjustment to a permanent revenue stream. In order to understand the pricing of the embedded option, you have to look at that report. But, geez, that’s enough detail for one day, eh?
Suffice it to say that pseudoModifiedDurationCost (that is to say, the modified duration calculated, not formulaicly, but by sampling of yield changes, using costYield as the yield measure) changes a lot for TCA.PR.X given its present price. The system has found (via backtesting) that trades that change this number substantially are riskier (in terms of ultimate results) than trades that do not change this number.
So in this case, the system wants to hang on to the existing issue – even though the valuation of CU.PR.A is higher – because the risk profile is so different.
Astute readers will have noticed that the trade size was reduced to zero due to the low volume on the CU.PR.A anyway!
The oracle has spoken!
I bought CU.PR.B for $25.10 (to yield 6.0%) instead of BMO new issue, so I’m happy.
If it wasn’t for your blog and willingness to have discussion, I would not have been alerted to this opportunity.
I’m just not sure that with all the debate and analysis it met my $300/hour criterion…..
Well … you picked up yield and you picked up quality, both at the same time. Just bragging about that trade is worth money!
go shopping today at “Merrill-Mart”
a/o 10:45 this am, Merrill Lynch has iceberg sells below last market on at least 50% of the fiprefs out there, and amazingly, investors are starting to eat into some of this value . . . some of the nonfistuff as well!
madequota
Does this mean that sophisticated investors (Banks and Merrill) are selling and dupes (me and other small investors) are buying?
or
Does it mean that institutional “income funds” have lost so much money on banks, prefs and income funds in the past year that individual investors are bailing out of the funds in sufficient numbers that the banks and Merrill are forced to sell mutual fund holdings?
Where I bank at TD Canada Trust, they have huge signs focussed on 10% 10-year returns from their income funds. GIC refugees probably don’t understand the risks (and the signs make no attempt to inform them with balanced commentary). I would not be surprised if they were fleeing in droves, forcing the banks to sell pref shares (and banks and income trusts).
If this scenario is correct, then who are the sophisticated investors, and who the dupes?
I’m not sure that your scenario might even be applicable to the Merrill thing right now. Whenever we have a new issue above market, there’s a flurry of shuffling in and out of issues for any number of reasons.
I don’t like the IPO thing as you know, because it causes at least short term account value deterioration.
I would say, based on what I saw Merrill do today, that there’s nothing sophisticated about what they’re doing. I would say in a number of cases, they have already proven themselves the dupes. Look at CIU.PR.A today . . . closely . . . Merrill left a pile of $$ on the table.
I’ll get back to you on your GIC scenario . . . have to give it some thought
madequota