Editor’s Letter

Ah, the “Dog Days” of August, when everyone takes off for the beach, or Europe (if you’re an American), or the United States (if you aren’t), or the mountains, or basically anywhere that isn’t the office! The weather is warm, life slows down, major problems seem far away and minor ones become somehow more bearable, and the stock market usually goes up. Of course, by the time you are reading this, it will be a lot closer to the end of summer, with the resumption of life as usual and the arrival of the hurricane season, both literally (think: Hurricane Sandy last year) and figuratively (think: Congress back in session).

While waiting for the inevitable arrival of September, let us turn to this issue of The Journal of Derivatives. We begin with two articles that combine analysis of a firm’s equity, bonds, and credit default swaps (CDS) to extract information about the underlying markets. In the first, Berg and Kaserer compare the risk-neutral default probability reflected in an issuer’s CDS spread against Moody’s KMV’s expected default frequency (EDF), which is meant to be an empirical, not risk-neutral, probability estimate. From the difference between them, the authors are cleverly able to infer the market’s expected risk premium on the firm’s equity. The second CDS article, by Giannikos, Guiguis, and Suen, looks at a different question: Among these three types of securities, all of which are closely tied to the underlying firm’s financial condition, which one is most important in price discovery? That is, which security responds first to the arrival of new information to the market and which ones follow? They find that information leadership is greatest for stocks, then CDS, and least for bonds. But CDS gained influence relative to equities during the financial crisis of 2008.

The next article proposes a new approach to incorporating dividend payouts in a binomial lattice. Discrete dividends cause the tree to splinter, which sharply increases the number of node calculations required for a given number of time steps. The current models force the tree to recombine after a dividend. Areal and Rodrigues suggest allowing the tree to splinter, which produces accurate valuation of the dividend payout, but economizing on the number of node calculations by pruning the tree in other ways. The result is a considerable performance improvement relative to current methods. Next is an article on perpetual American strangles. The contract sounds simple—just a call and a put with different strike prices—but valuation is tricky because exercise of one option cancels the other, making the early exercise decision nontrivial. Chuang develops a quasi-analytical solution to the problem.

Tuckman points out an important, and largely unappreciated, aspect of derivatives contracts that is vital in practice but mostly overlooked in theory. It is that our derivatives pricing models build in a “riskless rate of interest” that reflects the financing cost of buying and holding the underlying asset, and the derivatives contract effectively locks in that rate. But actually financing such a position in the real world rarely allows the rate to be fixed for the full duration of the trade. This creates financing risk that is not present in the derivative but is a fact of life for the real-world cash market transaction that theoretically replicates the derivative. In the final article, Kawaller and Koch weigh in on the perennially controversial topic of defining appropriate accounting rules for hedgers using derivatives. They show that the current measure of hedging effectiveness is flawed and suggest two alternatives.

One great thing about being an academic (or an economic policy pundit, these days) is that the consequences of being completely and publicly wrong are pretty small. Consider, for example, the “inflation hawks” who are still influential in both Washington and Europe despite being completely wrong in their projections that monetary stimulus such as the Fed’s series of QEs would cause runaway inflation, or even Reinhart and Rogoff, two academics whose strong policy prescriptions turned out to be based on a spreadsheet error. In my case, in my last Editor’s Letter, written in the middle of May 2013, I said: “As depressing as the situation in Washington may be, your Editor is soon to be distracted by a major biological event that is even worse: 17-year cicadas.” Well, I was wrong: The cicadas came, but they were nowhere near as bad as the situation in Washington, which shows every sign of becoming even uglier this fall, when Congress must agree on a budget for the next fiscal year beginning October 1, and on raising the debt ceiling sometime around the beginning of November. Failure on either of these contentious issues will lead to a complete shutdown of the U.S. government until they are resolved.

Best wishes to all. May you enjoy the rest of the summer, and survive the fall hurricane season.

TOPICS: Credit default swaps, statistical methods, simulations

Stephen Figlewski

Editor

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