The Valuation of Inflation-Indexed and FX Convertible Bonds

Issuing convertible bonds has become a popular way of raising capital by corporations in the last few years. An important subgroup is convertibles linked to a price index or exchange rate. In this paper we extend the convertible pricing models of Tsiveriotis and Fernandes (1998) and McConnell and Schwartz (1986) to the case of indexation of the promised payments of the convertible to a general price index or to the price of foreign exchange. The theoretical framework derived in this paper considers two sources of uncertainty: both the underlying stock price and the consumer-price-index (or equivalently foreign-currency) are stochastic, and incorporate credit risk in the analysis. The extensions of two models enable to establish upper and lower bounds for the price of the indexed convertible. We approximate the pricing equations by using Rubinstein (1994) three-dimensional binomial tree, and we describe the numerical solution. We investigate and compare the models with respect to the characteristics of the issuer, the economic environment and the security’s characteristics. Moreover, we demonstrate the usefulnes and the limitations of the pricing model by using convertible traded on the Tel- Aviv stock exchange.Convertible Bonds, Credit Spread, Pricing, Inflation, Foreign- Exchange

Pricing inflation-indexed convertible bonds with credit

Issuing convertible bonds has become a popular way of raising capital by corporations in the last few years. An important subgroup is convertibles linked to a price index or exchange rate. The valuation model of inflation-indexed (or equivalently foreign-currency) convertible bonds derived in this paper considers two sources of uncertainty allowing both the underlying stock and the consumer-price-index to be stochastic and incorporates credit risk in the analysis. We approximate the pricing equations by using a Rubinstein (1994) three-dimensional binomial tree, and we describe the numerical solution. We investigate the sensitivity of the theoretical values with respect to the characteristics of the issuer, the economic environment and the security’s characteristics (number of principal payments). Moreover, we demonstrate the usefulness and the limitations of the pricing model by using inflation-indexed and foreign currency linked convertibles traded on the Tel- Aviv stock exchange

BANK MANAGEMENT AND MARKET DISCIPLINE

In recent years market discipline attracted interest as a mechanism to augment or to partially replace government oversight (discipline) of the financial sector, specifically depository institutions. Despite the abundance of research, mostly empirical studies, in the area no formal model has been presented to analyze the different aspects of the issue. This paper attempts to fill this gap. In our model we incorporate the characteristics of the regulatory structure and market discipline and examine the effects of several parameters on the optimal decisions of the bank. For example we consider the effects of changes in risk, deposit insurance coverage, and degree of market discipline. In most cases our results are compatible with recent empirical findings

Liquidity Risk and Competition in Banking

Liquidity risk is one of the major risks faced by banks in addition to credit risk, market risk and operating risk. In this paper we construct a stylized model of bank management where the asset and liabilities liquidity structure are a key element in determining the bank's exposure to liquidity risk. The main results of our model are that liquidity risk increases when competition in the credit market increases while increasing competition in the deposit market will decrease the liquidity shortage. Our results are of particular importance as banks face increased liquidity risk due to the recent developments in the financial markets

Bank Management and Market Discipline

In recent years market discipline attracted interest as a mechanism to augment or to partially replace government oversight (discipline) of the financial sector, specifically depository institutions. Despite the abundance of research, mostly empirical studies, in the area no formal model has been presented to analyze the different aspects of the issue. This paper attempts to fill this gap. In our model we incorporate the characteristics of the regulatory structure and market discipline and examine the effects of several parameters on the optimal decisions of the bank. For example we consider the effects of changes in risk, deposit insurance coverage, and degree of market discipline. In most cases our results are compatible with recent empirical findings

Pricing Inflation-Indexed Convertible Bonds with Credit Risk

In Issuing convertible bonds has become a popular way of raising capital by corporations in the last few years. An important subgroup is convertibles linked to a price index or exchange rate. The valuation model of inflation-indexed (or equivalently foreign-currency) convertible bonds derived in this paper considers two sources of uncertainty allowing both the underlying stock and the consumer-price-index to be stochastic and incorporates credit risk in the analysis. We approximate the pricing equations by using a Rubinstein (1994) three-dimensional binomial tree, and we describe the numerical solution. We investigate the sensitivity of the theoretical values with respect to the characteristics of the issuer, the economic environment and the security’s characteristics (number of principal payments). Moreover, we demonstrate the usefulness and the limitations of the pricing model by using inflation-indexed and foreign-currency linked convertibles traded on the Tel- Aviv stock exchange

The 2007-2009 Financial Crisis and Executive Compensation: Analysis and a Proposal for a Novel Structure

During the 2007-2009 crises financial institutions have come under increasing pressure from regulators, politicians and shareholders to change their compensation practices in order to remove the incentive for short term excessive risk taking. In this paper we analyze first how the common executive compensation, which is composed of equity-based compensation (stocks and executive stock options) and a fixed cash compensation, leads to a concave relationship between assets risk and compensation value and creates an incentive for the executive to choose corner solutions that either lead to an excessive risk taking or to a freeze out of the lending activity to the public. This paper’s main contribution is a novel component, for executive compensation, that is paid only if the value of the firm assets is located in some predetermined range. This new form of compensation motivates the executive to take an intermediate (internal solution) level of assets risk because of the convex relationship between assets risk and compensation value

Loan Pricing under Basel II in an Imperfectly Competitive Banking Market

The new Basel Capital Accord (Basel II), published in its final form in June 2006, established new and revised capital requirements for banks. In this paper we analyze and estimate the possible effects of the new rules on the pricing of bank loans. We do that for the two approaches for capital requirements (Internal and Standardized) available to banks and make a distinction between retail (mainly households) and corporate customers. Our loan equation is based on a model of a banking firm facing uncertainty operating in an imperfectly competitive loan market. We use Israeli economic data and data of a leading Israeli bank, including probability of default of its retail and corporate customers. The main results indicate that high quality corporates and retail customers will enjoy a reduction in loan interest rates in (large) banks which, most probably, will adopt the IRB approach. On the other hand high risk customers will benefit by shifting to (small) banks which, most probably, will that adopt the Standardized approach

INFLATION EXPECTATIONS DERIVED FROM FOREIGN

Inflation expectations are a key economic variable for investors in capital markets and for economic policy decision makers. One of the widely used sources for deriving inflation expectations are market prices of bonds. The yield differential between nominal bonds and inflation-indexed (linked) bonds is taken to be an estimate of expected inflation. The problem is however that in a risk averse world the yield differential includes an inflation risk premium and thus the yield differential provides an upward bias of inflation expectations. The novelty of our paper is that we estimate this risk premium using volatility implied in options prices. In the absence of a market in options on inflation we use prices of foreign currency options to estimate this risk premium. The theoretical foundation of our methodology is purchasing power parity theory. The Israeli financial market has both, an inflation linked and non linked bond market and an active FX options market. Using data from both markets we find a statistically and economically significant inflation risk premium

Pricing inflation-indexed convertible bonds with credit

Issuing convertible bonds has become a popular way of raising capital by corporations in the last few years. An important subgroup is convertibles linked to a price index or exchange rate. The valuation model of inflation-indexed (or equivalently foreign-currency) convertible bonds derived in this paper considers two sources of uncertainty allowing both the underlying stock and the consumer-price-index to be stochastic and incorporates credit risk in the analysis. We approximate the pricing equations by using a Rubinstein (1994) three-dimensional binomial tree, and we describe the numerical solution. We investigate the sensitivity of the theoretical values with respect to the characteristics of the issuer, the economic environment and the security’s characteristics (number of principal payments). Moreover, we demonstrate the usefulness and the limitations of the pricing model by using inflation-indexed and foreign currency linked convertibles traded on the Tel- Aviv stock exchange