The Rules, Part LVIII: Mathematical Models, Investing, And Reality

The Rules, Part LVIII: Mathematical Models, Investing, And Reality by David Markel, CFA of the Aleph Blog

Can contingent claims theory for bond defaults be done on a cash flow/liquidity basis?  KMV-type models seem to fail on severely distressed bonds that have time to breathe and repair.

We’re getting close to the end of this series, and I am scraping the bottom of the barrel.  As with most aspects of life, the best things get done first.  After that diminishing marginal returns kick in.

Here’s the issue.  It’s possible to model credit risk as a put option that the bondholders have sold to the stockholders.  As such, equity implied volatility helps inform us as to how likely default will be.  But implied volatilities are only available for at most two years out, because they don’t commonly trade options longer than that.

Here’s the scenario that I posit: there is a company in lousy shape that looks like a certain bankruptcy candidate, except that there are no significant events requiring liquidity for 3-5 years.  In a case like this, the exercise date of the option to default is so far out, that the company can probably find ways to avoid bankruptcy, but the math may make it look unavoidable.  Remember, the equity has the option to default, but they also control the company until they do default.  Being the equity is valuable, because you control the assets.

Bankruptcy means choking on cash flows out that can’t be made.  Ordinarily, that happens because of interest payments that can’t be made, rather than repayment of principal.  If interest payments can be made, typically principal payments can be refinanced, unless credit gets tight.

The raw math of the contingent claims models do not take account of the clever distressed company manager who finds a way to avoid bankruptcy, driving deals to avoid it.  The more time he has, the more clever he can be.

This is a reason why I distrust simple mathematical models in investing.  The world is more complex than the math will admit.  So be careful applying math to markets.  Think through what the assumptions and models mean, because they may not reflect how people actually work.

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About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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