The VXX ETN and Volatility Exposure
By: Tim Husson and Craig McCann (Jun 2011)
Published in the PIABA Bar Journal, Vol. 18, No. 24, pp. 235-252.
Exposure to the CBOE Volatility Index (VIX) has been available since 2004 in the form of futures and since 2006 in the form of options, but recently new exchange-traded products have offered retail investors an easier way to gain exposure to this popular measure of market sentiment. The most successful of these products so far has been Barclays's VXX ETN, which has grown to a market cap of just under $1.5 billion. However, the VXX ETN has lost more than 90% of its value since its introduction in 2009, compared to a decline of only 60% for the VIX index. This poor relative performance is because the VXX ETN tracks an index of VIX futures contracts that can incur negative roll yield. In this paper we review the VIX index and assess the opportunities and risks associated with investing in the VXX ETN.
Modeling Autocallable Structured Products
By: Geng Deng, Joshua Mallett, and Craig McCann (Mar 2011)
Published in the Journal of Derivatives & Hedge Funds 17, 326-340 (November 2011).
Since first introduced in 2003, the number of autocallable structured products in the U.S. has increased exponentially. The autocall feature immediately converts the product if the reference asset's value rises above a pre-specified call price. Because an autocallable structured product matures immediately if it is called, the autocall feature reduces the product's duration and expected maturity.
In this paper, we present a flexible Partial Differential Equation (PDE) framework to model autocallable structured products. Our framework allows for products with either discrete or continuous autocall dates. We value the autocallable structured products with discrete autocall dates using the finite difference method, and the products with continuous autocall dates using a closed-form solution. In addition, we estimate the probabilities of an autocallable structured-product being called on each call date. We demonstrate our models by valuing a popular autocallable product and quantify the cost to the investor of adding this feature to a structured product.
Futures-Based Commodities ETFs
By: Ilan Guedj, Guohua Li, and Craig McCann (Jan 2011)
Published in The Journal of Index Investing, Summer 2011, Vol. 2, No. 1: pp. 14-24.
Commodities Exchange Traded Funds (ETFs) have become popular investments since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging.
This paper examines the sources of the deviation between futures-based commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs.
Leveraged Municipal Bond Arbitrage: What Went Wrong?
By: Geng Deng and Craig McCann (Oct 2010)
Published in The Journal of Alternative Investments, Spring 2012, Vol. 14, No. 4: pp. 69-78.
In this article, we explain that, while marketed as an arbitrage strategy, the leveraged municipal bond strategy was simply an opaque high-cost, highly leveraged bet on the value of call options, interest rates and liquidity and credit risk. Brokerage firms misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. We also show that much of the losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.
Related Awards:
- Puglisi v Citigroup - $750,000 MAT Five Award
- Young v Deutsche Park Securities - $1 million Aravali Fund Award
- Hosier et al v Citigroup - $54.1 million MAT Finance, MAT Two, MAT Three, MAT Five Award
- Coleman v Citigroup - $230,667 ASTA Five Award
- Beard v Citigroup - $336,000 ASTA Five Award
- Barnett et al v Citigroup - $2,428,000 MAT Five Award
Auction Rate Securities
By: Craig McCann and Edward O'Neal (Oct 2010)
Auction Rate Securities (ARS) were marketed by broker-dealers to investors, including individuals, corporations and charitable foundations as liquid, short-term, cash-equivalent investments similar to traditional commercial paper. ARS's liquidity and similarity to short-term investments were entirely dependent on the presence of sufficient orders to buy outstanding ARS at periodic auctions in which they were bought and sold subject to a contractual ceiling on the interest rate the issuer would have to pay. If the demand for an ARS was too low to clear the market, broker dealers sponsoring the auction could place bids just below the maximum interest rate to clear the auction. The lower the public demand for an issue, the larger the quantity broker dealers had to buy to avoid a failed auction.
Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers' holdings and inclination to abandon their support of the auctions. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms' strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities.
Leveraged ETFs, Holding Periods and Investment Shortfalls
By: Ilan Guedj, Guohua Li, and Craig McCann (Aug 2010)
Published in the Journal of Index Investing, Winter 2010, Vol. 1, No. 3: pp. 45-57.
Leveraged and Inverse Leveraged ETFs replicate the leveraged or the inverse of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%.
The Anatomy of Principal Protected Absolute Return Notes
By: Geng Deng, Ilan Guedj, Joshua Mallett, and Craig McCann (Jul 2010)
Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011.
Principal Protected Absolute Return Barrier Notes (ARBNs) are structured products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies.
What TiVo and JP Morgan teach us about Reverse Convertibles
By: Geng Deng, Craig McCann, and Edward O'Neal (Jun 2010)
Reverse convertibles are short term, unsecured notes issued by brokerage firms including JP Morgan, Barclays, Citigroup, Morgan Stanley, Wachovia, Lehman Brothers, and RBC that pay less than the notes' face value at maturity if the price of the reference stock or the level of the reference stock index declines substantially during the term of the note. The SLCG study finds that brokerage firms overcharge for reverse convertibles so significantly that the expected return on these complex investments is actually negative and that reverse convertibles continue to be sold at inflated prices only because investors do not fully understand these products.
The SLCG study reports that despite substantial overpricing in the offerings and the significant losses on the reverse convertible notes in 2008 and 2009, there have been a substantial number of new issues of these dubious investments by JP Morgan, Barclays and many others brokerage firms in 2010. The study illustrates its main themes with JP Morgan's May 14, 2010 TiVo-linked reverse convertible.
Oppenheimer Champion Income Fund
By: Geng Deng and Craig McCann (May 2010)
During the second half of 2008, Oppenheimer's Champion Income Fund lost 80% of its value - more than any other mutual fund in Morningstar's high-yield bond fund category. These extraordinary losses were due to the Fund's investments in credit default swaps (CDS) and total return swaps (TRS). The Fund used CDS and TRS to leverage up the Fund's exposure to corporate debt and asset-backed securities, including Mortgage-Backed Securities and swap contracts linked to Residential and Commercial Mortgage-Backed Securities indices.
What Does a Mutual Fund's Term Tell Investors?
By: Geng Deng, Craig McCann, and Edward O'Neal (Apr 2010)
Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.
In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds.
