A newly Assiduous Reader who is also new to the market writes in and says:
Today, RY.PR.P did not trade AT ALL until after 12:00! Is the market for prefs that illiquid? The price also swung from being below the value of RY.PR.R to ending above the value for R. In my opinion ONLY, the price for R should be higher then the price for P if you are a long term investor. Therefore I question my understanding of pricing in this marketplace!
You and me both, brother, you and me both.
This month’s edition of PrefLetter (currently at the Graphic Artist’s Spa, having its hair done and nails manicured) will contain a section with a new pricing model for Fixed-Resets … so I won’t discuss it here. Instead, I will refer to my last post on Sloppy, Sloppy Markets and take another look at a not-entirely-randomly chosen example of market inefficiency in the Pereptual Discount sector.
BMO PerpetualDiscounts
Closing, Feb 13 |
| Issue |
Annual
Dividend |
Quote |
Bid Yield-to-Worst |
Ask Yield-to-Worst |
| BMO.PR.J |
1.125 |
16.76-80 |
6.75% |
6.74% |
| BMO.PR.K |
1.3125 |
18.81-94 |
7.02% |
6.97% |
| BMO.PR.H |
1.325 |
21.46-70 |
6.21% |
6.13% |
| BMO.PR.L |
1.45 |
20.57-96 |
7.10% |
6.94% |
This table presents a difficult question to Efficient Market zealots – who implicitly presume infinite liquidity as part of their efficient market. How on earth is it possible to rationalize the quotation on BMO.PR.H?
We’ll review a little … I estimated in my 2007 essay on convexity that being 15% or more away from the call price was worth about 15bp in yield; that is, a PerpetualDiscount trading at around $21.75 should yield about 15bp less than a similar issue from the same issuer trading at par; the higher coupon / higher price issue should yield more since any gains from a decline in yields should be expected to be called away, while the lower priced issue has a higher potential for capital gains.
We can argue for as long as we like regarding details such as:
- 15bp yield difference?
- 15% price range of effect?
- straight line or curved effect?
but there definitely should be an effect and this effect should be positive. In June of 2008 this relationship went negative … while the curve returned to normal after a little while, it certainly resulted in a poor month for the fund I manage. It is these episodes in which the market defies common sense that make leverage such a dangerous game!
Note also that the ModifiedDuration of PerpetualDiscounts (which is a measure of price sensitivity to yield changes) is – to a first approximation – dependent solely upon the yield of the instrument. Any PerpetualDiscount with a given yield has the same yield risk as any other PerpetualDiscount with the same yield, except as distorted by the potential for calls taking away your winnings. So we can’t use yield-sensitivity as an argument.
In sum, I have to advise my newly Assiduous Reader to relax and enjoy the market inefficiency. Once you have a decent model for prices, you can make good money by exploiting transient anomalies and waiting for them to correct. This will increase your turnover and therefore your commission cost (which concerns a lot of people who are inspired by regulatory emphasis on the Trading Expense Ratio), but all moneymaking endeavors have some kind of cost.
Further examples of inefficiency and pricing models for PerpetualDiscounts will be presented at the seminar on February 26. Or, if you don’t want to do it yourself, you can always consider an investment in my fund, which uses many pricing models to check each other and is always on the prowl for anomalies.
This entry was posted on Sunday, February 15th, 2009 at 3:16 pm and is filed under Reader Initiated Comments. You can follow any responses to this entry through the RSS 2.0 feed.
You can leave a response, or trackback from your own site.
Pref Market Inefficiency Shocks New Player
A newly Assiduous Reader who is also new to the market writes in and says:
You and me both, brother, you and me both.
This month’s edition of PrefLetter (currently at the Graphic Artist’s Spa, having its hair done and nails manicured) will contain a section with a new pricing model for Fixed-Resets … so I won’t discuss it here. Instead, I will refer to my last post on Sloppy, Sloppy Markets and take another look at a not-entirely-randomly chosen example of market inefficiency in the Pereptual Discount sector.
Closing, Feb 13
Dividend
This table presents a difficult question to Efficient Market zealots – who implicitly presume infinite liquidity as part of their efficient market. How on earth is it possible to rationalize the quotation on BMO.PR.H?
We’ll review a little … I estimated in my 2007 essay on convexity that being 15% or more away from the call price was worth about 15bp in yield; that is, a PerpetualDiscount trading at around $21.75 should yield about 15bp less than a similar issue from the same issuer trading at par; the higher coupon / higher price issue should yield more since any gains from a decline in yields should be expected to be called away, while the lower priced issue has a higher potential for capital gains.
We can argue for as long as we like regarding details such as:
but there definitely should be an effect and this effect should be positive. In June of 2008 this relationship went negative … while the curve returned to normal after a little while, it certainly resulted in a poor month for the fund I manage. It is these episodes in which the market defies common sense that make leverage such a dangerous game!
Note also that the ModifiedDuration of PerpetualDiscounts (which is a measure of price sensitivity to yield changes) is – to a first approximation – dependent solely upon the yield of the instrument. Any PerpetualDiscount with a given yield has the same yield risk as any other PerpetualDiscount with the same yield, except as distorted by the potential for calls taking away your winnings. So we can’t use yield-sensitivity as an argument.
In sum, I have to advise my newly Assiduous Reader to relax and enjoy the market inefficiency. Once you have a decent model for prices, you can make good money by exploiting transient anomalies and waiting for them to correct. This will increase your turnover and therefore your commission cost (which concerns a lot of people who are inspired by regulatory emphasis on the Trading Expense Ratio), but all moneymaking endeavors have some kind of cost.
Further examples of inefficiency and pricing models for PerpetualDiscounts will be presented at the seminar on February 26. Or, if you don’t want to do it yourself, you can always consider an investment in my fund, which uses many pricing models to check each other and is always on the prowl for anomalies.
This entry was posted on Sunday, February 15th, 2009 at 3:16 pm and is filed under Reader Initiated Comments. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.