Wednesday, 19 October 2011

Anatomy of a convert - prehistoric rational expectations

I'd love to know the history of the kinds of clause which are typically found in modern day convertibles.  I'm sure each clause would have a fascinating history.  But in the meantime I'd just like to point out first of all that these clauses individually do have a cultural history - somebody invented each and every one, at a specific time, and for a specific purpose.  Either they allowed a potentially failing new issue to go through, or they smuggled in a 'screw you' clause which wasn't well understood by either the issuer themselves, or by the  marketplace.

Second, I'd like to point out just how many of them can be cashed out in terms of algorithms.  Modern convertible pricing systems can turn pretty much every significant clause into a cash-now contribution towards the overall fair value of any convert.  That is quite amazing to me.  

And most interesting of all is that convertibles have existed for quite some time.  Whereas the modern pricing of options traces its origins to the late 1960s only.  How on earth did market participants manage to run that market in the absence of a decent convertible model?  Well, probably profitably.

One way of looking at these 'prehistoric' times for convertibles is to imagine how the disciples of rational expectations would explain what would have been going on back then.  How does a rational agent (or the average rational agent) manage to come up with a market price for a convertible in the absence of a coherent modern convert model.  I guess that the best model available would be the next best target for a prehistoric rational agent?  Certainly it could be the case that the average opinion of prehistoric market participants would be close to the average opinion of current market participants, with perhaps more variance.  But my gut feeling is that this would have been unlikely.  In other words, there was probably some kind of unrecognised persistent bias in the prices of certain prehistoric convert issues.  Really?  Could this be?

And what about the instant that the first step change in convertible pricing occurred?  I guess around the time of E.O. Thorp.  What if he decided not to publish his book on convertibles, but had kept it to himself.   Wouldn't he have an edge?  Wouldn't the market price be inefficient insofar as E.O. Thorp decided to leave money on the table back in the late '60s?  Rational expectations can never be about market efficiency in any absolute sense, but there must surely be an evolution of expectations.  Which means there ought to be a whole series of incrementally more efficient insights and practices when it comes to judging the market's efficiency at any one time, even now.

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