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Ari Pine is an independent trader in the equity, futures & f/x markets. After 10 years of trading gold and silver options on the Comex and proprietary positioning across global asset markets, Ari is putting together a research based framework for managing money. Ari holds a Bachelor of... More
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  • The Fed, The Shadow Banking System And The Law Of Unintended Consequences

    From my blog

    Andy Kessler writes on the opinion page of the Wall Street Journal about Fed policy, collateral and the shadow banking system. This is definitely an inside baseball type story. But this is a case where the detail work makes a big difference to the big picture. The quick version is that banks use high quality collateral, i.e., government and mortgage debt, to create credit. They do this by re-hypothecation in the repo (repurchase agreement market). His point is to criticize Fed policy, presumably with the idea of "correcting" it. If he is correct, and I think that he is at least partially correct, then the immediate implications are far more interesting than a critique of Fed policy.

    First, here is a bit of background. A repo is nothing more than a collateralized loan. For example, I purchase a 10 year note and want to finance it. The cheapest way to do so is in the repo market where I post the note as collateral. It is called a repurchase agreement because rather than create a loan, I simultaneously sell the note to the bank and negotiate a forward "repurchase" of it. Voila. The bank is happy because it has a liquid asset backing its loan (not like a house) and it has a very good handle on its value. Plus it demands the loan be over-collateralized. I'm happy because I'm getting an extremely good rate due to the safety of the loan.

    The bank now has a 10 year note on its balance sheet. Banks don't like to waste balance sheet; they get measured on their efficient use of it. So the bank does a repo with the 10 year note from me. Now they have the cash, minus the overcollateralization amounts. Bam! Money created. That process is called re-hypothecation (simply because the original loan is called hypothecation. Fortunately, the next transaction is still called re-hypothecation and not re-re-hypothecation.).

    Before anyone lays down judgment on how this shows how banks shouldn't be able to create out of control fiat credit, please realize I'm reporting what happens. I'm not interested right now in whether it is a good idea or not.

    The first question is whether he is correct. There is no doubt that the Fed is buying truckloads of bonds. This article from Bloomberg in December estimates that the Fed will be the buyer of 90% of new dollar denominated assets. The Fed focuses on the highest quality (most credit worthy and liquid) issues, i.e., government and mortgage debt. So there clearly is a critically small amount of issuance available. Further, this IMF paper documents the re-hypothecation in the banking system.

    To review: 1) The Fed's QE policy is reducing the amount of usable collateral for hypothecation, 2) this collateral is critical for the "shadow" banking sector, and 3) the "shadow" banking sector is a larger credit creation mechanism than the Fed's QE. The Fed has stated that its goal is to keep QE going until economic growth gains momentum. Based on this analysis, the clear conclusion is that right as the Fed wants to unwind QE to take the pedal off of the gas, collateral will become available and the credit creation from the shadow banking system will kick in. The implication is that the Fed will have trouble keeping credit creation under control and that inflation will become a real risk.

    Tags: Macro, Economics
    May 31 12:11 PM | Link | Comment!
  • Apple Dividend Play Follow-Up

    Anyone who has never made a mistake has never tried anything new.

    Albert Einstein

    On April 15, I wrote an instablog post on SeekingAlpha. It explained how the forward price of a stock is impacted by its dividend and how to structure an options trade that should benefit from a higher dividend. The article went through scenarios for purchasing a conversion on Apple (NASDAQ:AAPL) and the cash flows. As it turns out, Apple did raise its dividend. I'm going to go through the market results so far.

    First, let's review the trade and what happened. I suggested looking at Jan 2014 conversions. Mid-market was $7.03 and I wrote that it would likely cost $7.50 to get into the trade. At the time of the article, AAPL's dividend was $2.65 per quarter. On their earnings announcement, Apple raised its dividend to $3.05 per quarter. It turned out that was below my "conservative" estimate of $3.60 based on matching the yield of other, similar tech giants. Instead, Apple's management chose to enhance shareholder return primarily through buybacks.

    It is now May 2nd. As I write this, AAPL is $447. It's next ex-dividend date is May 9. We can reasonably expect two additional dividend payments of $3.05 prior to the Jan 18th 2014 option expiration. Likely dates are August 8th and November 7th (I'm predicting Thursdays). I'll continue to use a discount rate of 0.5% as I did in the prior post. Had AAPL still had a $2.65 dividend (to be clear, it doesn't), then the forward would be:

    F = $447e(.005)(.715) - $2.65e(.005)(.696) - $2.65e(.005)(.447) - $2.65(.005)(.197) = $440.63

    Since AAPL actually did change its dividend, its forward will now be:

    F = $447e(.005)(.715) - $3.05e(.005)(.696) - $3.05e (.005)(.447) - $3.05e (.005)(.197) =$439.43

    That is a difference of $1.20, which, due to near zero interest rates, is the same as the difference in three dividend payments of 40c each. So far, so good. One expects the conversion to move the same amount, too.

    Recall that we valued the forward at $6.17, but that the mid-market price was at the time $7.03. The market appeared to be pricing a move in the dividend. Given the scenarios that I had envisioned, it appeared to be a worthwhile risk to pay $7.50 based on the scenarios in the Expectations section of the post. The current Jan 2014 at-the-money (ATM - meaning those options closest to the forward price of AAPL) conversion is $6.62-$7.56, with a mid-market of $7.09. Putting things together, our forward calculations moved from $6.17 to $7.57 ($447 - $439.43). Note that is a difference of $1.40, not $1.20. Those extra 20c are the interest costs that already were paid for holding the trade since April 15th.

    Where is the difference between the forward and the current conversion price from? From the early exercise provision of American style options. This is where the quote from Einstein comes in. As it turns out, it is the quote for the chapter "Options on Stocks that Pay Discrete Dividends" from Espen Haug's excellent The Complete Guide to Option Pricing Formulas book. I've no idea what motivated him to put that quote with that chapter, but it fits well with my situation. Perhaps he, too, made a mistake in a dividend exercise situation. Or perhaps he was referring to the Roll-Geske-Whaley model which had been used to price options with dividends but turns out to be incorrect. At any rate, my problem is that in addition to putting this trade on with options expiring Jan 2014, I also put it on with options expiring May 17, 2013 (in 2 weeks). It will make a nice illustration of dividend driven early exercise risks.

    Starting with the 2014 conversion, if one gets an appropriate option model that can properly handle discrete dividends (hence my dive back into Haug's book), the theoretical price of the Jan 2014 440 conversion when AAPL is $447 is $7.31; note for European style options it is $7.58 - matching our forward. The early exercise makes a difference, albeit only a 27c difference. Why should early exercise matter? Because should Apple rebound, the extrinsic value of the call can become less than the dividend to be earned. Another way of looking at this is to compare the deep call with its analogue put. If the extrinsic value for the corresponding put is less than the dividend, one exercises the call to own the stock just prior to the ex-dividend date. For options expiring in 2014 with 3 dividends and a lot of extrinsic premium, it doesn't matter much.

    But for the May 17, 2013 options, it matters a lot. Consider that I purchased the May 400 conversion for $2. Now that AAPL is $447, those May 400 puts are not worth much. Right now they are trading around 74c. 74c is considerably lower than the dividend of $3.05. Why do I care about the puts? We are talking about the calls. A position of long 1 call and short 100 shares is (most of the time) equivalent to one put. This is called a synthetic and it requires explaining on its own, but stick with me. If a trader has a position of long call and short stock, it pays to exercise the calls to collect the dividend. The trader can replicate the same risk profile by purchasing the puts for 74c in the open market. Think about that for a moment. He exercises the call which is equivalent to selling it, receives shares that pay him/her $3.05 and then creates the same risk position by buying puts for $0.74.

    That was my mistake. I was technically short AAPL and didn't realize it. I had paid $2 for the conversion thinking I would collect my dividend. But since AAPL rallied 10% those puts are not worth much at all. I'm probably going to get my shares called away from me so that some other guy will get the $3.05. D'oh.

    Disclosure: I am long AAPL.

    Additional disclosure: I am long conversions and call spreads in AAPL

    Tags: AAPL, Options
    May 03 8:06 AM | Link | Comment!
  • Isolating A Dividend Play On Apple

    This article shows how to construct a favorable risk/reward trade to capitalize on an increased dividend from Apple.

    Apple Computer (NASDAQ:AAPL) currently has about $137B of cash & securities on its balance sheet (source: Apple 10Q ending 29 December 2012). There have been an increasing number of investors and commentators requesting or suggesting that Apple distribute some of this cash to its investors. There have been more than a few suggestions as to the how, including a special dividend and increasing the current cash dividend. David Einhorn of Greenlight Capital has directly addressed the issue in the media and in the courts. We know that Apple is aware of the discussion, aware of the cash and aware that the decline in its market capitalization regularly appears on financial news outlets.

    If one wishes to speculate on whether Apple will issue some sort of dividend change, it would be attractive to isolate a dividend play from an investment in Apple itself. For one thing, it is not obvious that some sort of change to the cash payout will benefit or harm Apple's stock price. While there is an OTC product (dividend swap) that is available, for retail and smaller institutional investors (or professionals that avoid OTC products) that is not available. However, with a little bit of knowledge of how forward pricing works, one can create a trade with an attractive risk/reward payoff in the options market.

    Forwards & Futures

    Investors in foreign exchange markets are quite familiar with forwards but for the most part, equity investors don't include forwards in their thinking. Take a moment to consider what a forward price is and how to calculate it, because this will show us how to construct a near pure play on Apple's future dividend payouts.

    A forward price for a security is the price that one would pay for an asset at a future moment in time. The forward price would then depend on the current price of the asset, the current appropriate interest rate and any dividends. I've simplified the general formula so that the forward price F can be calculated as:

    F = SerT - D1er(T-t1) - D2er(T-t2) …

    Here S is the current (spot) price of the shares, r is the financing rate, Dn is the nth dividend payment, T is the number of years from now until the forward contract matures and tn is the time from the nth dividend payment until the forward matures. The complete forward price formula can easily be found on Wikipedia. A full discussion is too much of a diversion; the key point is that we need to move the cash flows in time from now (spot) to the point in the future when the forward contract comes due.

    A quick example may help. AAPL is trading at $443 and has a dividend coming up around May 9 and we will calculate the value of a forward maturing May 31. Today is March 29 and there are 63 days in the forward. T = 63/365 = .173. D1 = $2.65; t1 = 22/365 = .060; r = 1%; S = $443.

    F = $443e(.01)(.173) - $2.65e(.01)(.173-.060) = $441.11

    Note that without the dividend payment, the forward price would be greater than the spot price. This is because one does not need to finance the purchase of the shares for 63 days and that is worth money. Also note that the dividend causes the forward price to be worth less because the dividend payment makes it more attractive to hold the shares as compared to the forward.

    One last thing worth mentioning is that it is still important to use the formula whether one borrows money or not. This is because if one invests in the spot today, those funds are unavailable for investment and the return r is forsaken. Right now r is very low, but this won't always be the case and in any event low is not zero.

    The Forward Price(s) of Apple

    We can't trade a forward on Apple shares directly on an exchange, but we are able to trade stock futures and we can also trade the forward price via options. Since we don't know the timing of when an announcement might be made, it would be helpful to have as long a horizon as possible - perhaps about one year - to allow some margin of error. As it turns out, single stock futures on AAPL extend only to the Sep 2013 contract, which is about 6 months. Options are available that extend out as far as Jan 2015 and the bid-ask spreads are tighter than for AAPL stock futures. We can create "synthetic" AAPL shares by purchasing a call and selling its corresponding put (the put that has the same expiration date and strike price). A conversion is selling call, buying put and buying shares; in other words, buying the shares now and selling synthetic shares (a forward) at some point in the future.

    Consider the options expiring Jan 18, 2014. Apple resumed dividend payments Aug 2012 and has been paying $2.65 each quarter with an ex-div date around the 9th of the month. Based on that history, we can expect that dividends should be paid in May, Aug and Nov. A forward price can then be calculated based on $2.65 per share paying out May 9, Aug 8 and Nov 7 and using an interest rate of 0.5%:

    F = $443 x e(.005)(.808)-$2.65e(.005)(.696)- $2.65e(.005)(.447)-$2.65e(.005)(.197) = $436.83

    One can buy AAPL shares and sell a forward contract. This eliminates the market risk of holding AAPL. The cost for that is $443-$436.83 = $6.17. Because you buy high ($443) and sell low ($436.83), you end up paying $6.17 for $7.95 worth of dividends (the difference of $1.78 is the cost of holding AAPL shares for 295 days at 0.5%). If AAPL raises its dividend, then the holder of AAPL receives more than $7.95 and then it is worth more than $1.78 to pay for the cash flows and the forward price goes lower.

    Current Market Pricing

    Closing prices from March 28th show that the forward price (buy call, sell put) is bid $434.8 and offered $436.45. Or, market makers are willing to buy the forward for $6.21 and sell at $7.86. Mid-market is $7.03. This is slightly higher than the $6.17 that we calculated using 0.5% -- which is a rate which is roughly available via Interactive Brokers for borrowed amounts above $1,000,000. This is a reasonable financing rate for institutions. If your funding costs are 1%, then calculating as before, the cash flows are worth $4.39 (see scenario 1: $7.95-$3.56=$4.39) and the economics of the trade are less compelling. This is a trade that depends heavily on financing.

    Next, consider some scenarios for what Apple can do with its dividend policy. First, they can do nothing and this trade does not work. Second, a popular suggestion is to double the dividend amount. Third, they can pay a special dividend of some amount. If they pay a special dividend, stock options will adjust strikes based on the amount of the special dividend and, therefore, that will not have an impact on the position.


    Cost of Money

    Scenario 1

    No Change in

    Dividend Policy

    Scenario 2




    Pay $7.5 for conversion

    Receive $7.95 in divs

    Pay $3.56 in interest

    Lose: $3.11

    Pay $7.5 for conversion

    Receive $15.9 in divs

    Pay $3.56 in interest

    Make: $4.84


    Pay $7.5 for conversion

    Receive $7.95 in divs

    Pay $1.78 in interest

    Lose: $1.33

    Pay $7.5 for conversion

    Receive $15.9 in divs

    Pay $1.78 in interest

    Make: $6.62


    Pay $7.5 for conversion

    Receive $7.95 in divs

    Pay $0 in interest

    Make: $0.45

    Pay $7.5 for conversion

    Receive $15.9 in divs

    Pay $0 in interest

    Make: $8.4

    Note how dependent this trade is on financing costs. I consider the 0.5% the more likely cost of funding for an institutional investor and, therefore, look at the middle row as the most appropriate for them. I've included 0% for retail investors who have excess cash and are looking for an investment. Interest for cash balances may as well be 0% -- even if one purchases a CD, there is very little to be earned. So if the choice is t-bills at 0.1% or investing in a conversion, then the bottom row is a reasonable way to look at it.


    It isn't enough simply to construct the trade and look at outcomes. We need to figure out some probabilities for what may occur. After combining the outcomes and the probabilities, we will have a better idea of the quality of the trade. I'd like to start with some data points to come up with possible scenarios and then look at what the market has priced in. For all scenarios, I'll assume a 0.5% cost of financing.

    First, CSCO has just increased its dividend to 68c per share for a yield of 3.25%. This compares with MSFT at 3.2% and INTC at 4.1%. Right now, AAPL pays 2.4%. A 3.25% yield would correspond to an annual dividend of $14.39 and quarterly payment of $3.60. Scenario one then can play out as an increase of dividend at the next announcement for three payments of $3.60 instead of $2.65. This leads to a profit of $1.52. This seems like a conservative scenario since it does make sense for Apple to increase the dividend, there has been shareholder pressure to do so and CSCO, without any such activism, has done the same. For argument's sake, let's assign the probability as 75% raise to $3.60 and 25% for no change. The expectation is then (25%)(-1.33)+(75%)(1.52) = 81c, a positive outcome, albeit one for which one is risking $1.33.

    Second, consider a rosier scenario. Let's keep the same 25% chance for no change in dividend policy. Let's also consider that if Apple does raise its dividend, that it is 50-50 whether it double it or raises it to a yield of 3.25%. Then the expectation becomes (25%)(-1.33) + (37.5%)($1.52) + (37.5%)($6.62) = $2.72.

    At this point, you can see how the potential outcomes, probabilities and trade setups can spiral into an infinite set of choices. It is up to the reader and investor to put together an appropriate package of assets, costs (including transaction costs), probabilities and outcomes that is most suitable, if at all, for their situation.

    Tailoring the Trade

    Needless to say, there are endless variations on the particular circumstances of the trade and one's view on probabilities and outcomes. For instance, the current market price of the conversion might move or one's financing rate might not be included in the table. Or one might want to use shorter or longer duration option expirations.

    Here are my goals with this note:

    1. Provide an interesting and, I believe, positive expectation trade
    2. Show how one can use options in a new way
    3. Show how I look at a potential trade
    4. Provide some tools for analyzing a trade
    5. Show that it is important to understand the instruments in the market and that by understanding how they work, find novel and potentially market underappreciated trades

    Disclosure: I am long AAPL.

    Additional disclosure: Disclosure:I am long AAPL stock via conversions.

    Apr 15 10:22 PM | Link | Comment!
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