Generating Alpha With Asymmetry

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During their latest episode of the VALUE: After Hours Podcast, Kao, Taylor, and Carlisle discuss Generating Alpha With Asymmetry. Here’s an excerpt from the episode:

Michael: Long story short, during my years at Canyon, they let me have the ball and run with it. I had this idea of creating a business within a business. I wrote a paper in probably circa 1998, I entitled it alpha with asymmetry. The general thought was that convertible and capital structure arb strategies tend to be long gamma, long optionality. Merger arb strategies and event driven strategies generally tend to have short gamma characteristics. The way I explained that is always that, if you think about a friendly deal where you’ve got a 95% chance of making a dollar, if the deal closes in, that 5% chance of a deal bust, you might lose $10. Well, that awfully sounds like short optionality to me.

So, my thought was, what if I created a business where these two asset classes could be paired and systemically hedge one another. But if you could be very smart and diligent about security selection, you might be able to create alpha with a lot of asymmetry. And so, that was the strategy that I started and ran at Canyon, and then wound up porting over to my own firm in 2002.

Tobias: So, let’s just talk a little bit about Akanthos in a little bit more detail and we’ll go back through what you’ve said. Because this is a value podcast, we might need a little bit more explanation of some of those terms.

Michael: Sure. Sorry, rephrase the question. What was I doing at–?

Tobias: Yeah, tell us a little bit about Akanthos and then we’ll go through those strategies just a little bit more, because for the most part, we’re vanilla long only value here, and we probably need some more explanation of some of those things.

Jake: [unintelligible [00:17:14] terms.

Michael: Yeah. So, look, I think by focusing on– At Canyon, the portfolio that I ran was always very convertible centric. The reason why I chose the convertible asset class to focus on was one. There really was no single analyst at Canyon focused on it, because most people focused there on either senior secured debt or senior unsecured high yield debt. Convertibles are an interesting asset class, because they touch upon credit, obviously. They also touch upon equity valuation, and they obviously also touch upon optionality. That’s very, very appealing to me.

In that period of time also, convertibles as an entire asset class, I would say, were a value asset class, because they were pretty mispriced. I remember giving this pitch to investors all the time that– I wish I had a graphic to show you, but if you think of the proverbial hockey stick of an equity option, now think about it from the standpoint of the Merton real options model. So, if you think about a firm’s equity as a real option on its assets, you can now think of that as, “Okay, the strike price of that option is the amount of debt, because by the accounting identity, equity equals assets minus liabilities.” So, that equity option is basically a call option. I’m going to try to frame it. It’s a call option on the firm’s assets. But debt to the investor standpoint is a short put. So, let’s see. If this is a call option, then a short put looks like this.

Why is that? Because the strike price of that put, by the way, is the amount of assets that are required to make the debt whole at par. When you buy a bond, you have a fixed income upside. You are getting your upside purely by the coupon and the yield. Well, that’s actually akin to the premium that you get from selling an option. But why is it a put option? Well, it’s because that if the assets exceed liabilities by so much and stock goes to the moon, well, the bondholder is just going to get par at the end of the day. But what happens if the underlying company falls into financial distress where the asset value of the firm drops below the par amount of debt outstanding? Well, then your bonds have equity, like, downside, so you are short of put on the firm’s assets.

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