Saturday, 10 December 2011

Anatomy of a convert - reckoning is not paying

In finance there's a useful difference made between the role of a calculation agent and the role of a payment agent.  Think of the calculation agent as the person (or process) whose job it is to digest the terms and conditions of a security, then on certain agreed days, to perform some calculation which can have a material impact on the value of the security, or on the decision to pay certain cash flows.  The security in question can be a convertible bond (among many others) and it is really a contract between the owner and the issuer.  In an ideal world, both the owner and the issuer will have a calculation agent on hand, to make sure no mistake is made in the periodic reckoning which is done.  

Related to this, but separately, is the implementation of any real payments which arise as the result of the monitoring performed by the calculation agent.  Both have synchronised calendars, but distinct calendars nonetheless.  Think of the calculation agent as the in house quant, and the payment agent as the operations department, if you like.

A good word for this calculation activity is to think of it as reckoning.
before 1000; Middle English rekenen, Old English gerecenian (attested once) to report, pay; cognate with German rechnen to compute
A reckoning is done a number of times during the life of the security's contract, and they need to be done on those particular days probably because they need a read or two from reality - perhaps a check on that day's interest rate, perhaps a read on whether that day is an unexpected non-business day.  On those observation dates, reality interacts with the terms and conditions of the security.  The result might change the state of that security, and that change of state may have implications for some transfer to be made - a coupon payment, an issuer call, a dividend payment, a holder's decision to put a bond back to the issuer, a stock price passing through a trigger level, an issuing company having accepted an offer to be bought or merged.  Often a security is observed by an independent, mutually agreed calculation agent, so as to reduce the likelihood of argument.  It is up to the writer of the security's terms and conditions to be as explicit as possible when defining the rules which need to be obeyed on upholding this contract. 

It is a useful thought to have in your mind the idea of multiple known and unknown calendar dates in the future which constitute that security's reckoning dates.  Many of those dates are known from day one, but many others can't.  For example, it may be the case that for a 20 year coupon paying bond, the expected coupon payment date in year 19 has by then become a public holiday.  So you can't write specific dates into such a contract.  You need to provide a set of rules with some flexibility to cope with surprising future states of the world.  We use day count conventions and business day conventions to help with this kind of uncertainty.  The result is a contract which, while seemingly cluttered with legalese and sometimes baffling circumlocutions, provide a robust framework for the calculation agents, the reckoners, to move it through the various stages of its investment life.  Payment is in a sense dependent on reckoning, and itself feeds back into future reckonings.  As we'll see, a convertible will have many many days of reckoning during its trandeable life.