• Alter Securities

Derivatives 3.0: Tranched Value Securities

Updated: Oct 5, 2019

A new generation of financial derivatives – trade junk assets securely, and leverage returns of risk-free assets without leverage.

Imagine a world where you can transfer your financial risks or get exposure to the desired returns by using some kinds of instruments, which at the same time can help you to hedge undesirable risks. This is exactly what traditional derivatives are meant to be. As a result of their benefits and efficiency for investors, global OTC derivatives market has grown from nearly $80 trillion in 1998 to almost $700 trillion at the peak in 2011, and slightly over $500 trillion in 2017, which is 6x times greater than global GDP according to IMF.

Source: Bank for International Settlements (BIS)

Despite the importance and size of global derivatives market, and continuous developments, there has been little improvements to the actual structure of derivatives, since the mid-18th century when first asset-backed securities (ABS) were issued. Since those years and until now, most of the existing derivatives split various pooled assets or pooled cash-flows from the groups of assets using different types of combination of forward commitments (obligatory agreement between two parties to carry out a transaction in the future, such as forwards and futures) or contingent claims (contract with payout that depends on realization of some uncertain future event, such as options) with slightly modified parameters, transforming the performance of underlying. However, now is a different time.

Based on the recent developments, we are living in the age when new types of derivatives are to be issued soon – Tranched Value Securities (patent pending). 

Tranched Value Securities are first described in the paper published on SSRN: Tranched Value Securities.

Tranched Value Security (TVS) is a security whose income payments, and hence value is derived from and collateralized (or "backed") by the value of a single asset, group of assets, stream of cash-flows or any other entity or product possibly having a determinable value (and / or price). Value of TVS is derived either from a value share of a specific underlying, or from a minimum contract value, which can be a value share of a specific underlying at the contract initiation, given that a higher-level (or “prior”) TVSs are satisfied.

So, what does it all mean? – It means that now, even if you and your peer hold the same asset or any other instrument, whether it’s currency, fixed-income or even other derivatives, during the same holding period, both of you can earn different return rates, depending on your value tranche seniority, even if both of you do not do any other actions with your holdings.

How does it work? – Quite simple! You provide underlying to the holding entity, and the holding entity securitizes underling by issuing various value tranches backed by the same underlying, each having a different value claim priority and possibly a different value share of the value of underlying.

This implies the following payment model:

where TVS_i_t is the value of Tranched Value Security (TVS_i), i.e. i-th value tranche at time t=n of underlying (S_t); S_t is the price of underlying at time t=n; w_i is the fixed weight of i-th value share corresponding to the specific underlying (S_t) at the contract initiation (t=0); X_i is the minimum corresponding value of TVS_i share at any time, which is set fixed and equals to w_i x S_t during the contract initiation at t=0; TVS_i-1_t is the value of higher-ranked Tranched Value Security (TVS_i), i.e. i-1-th value tranche at time t=n of underlying (S_t), which must be satisfied before any subsequent Tranched Value Security (TVS_i+1) can be fulfilled.

To illustrate this model, imagine that on 1st January 2007, five Tranched Value Securities were issued with one General Electric Ordinary Common Stock (NYSE: GE) as underlying when the opening price for GE was $37.41. The TVSs had 30% (GETVS-A – TVS Senior), 25% (GETVS-B – TVS Subordinated), 20% (GETVS-C – TVS Junior), 15% (GETVS-D – TVS Mezzanine), and 10% (GETVS-E – TVS Equity) value share claims (where all value share claims sum up to 100% of GE) of the underlying, and set fixed to equal $11.22, $9.35, $7.48, $5.61, and $3.74 minimum value claims (where all minimum value share claims sum up to $37.41 of GE) if the higher value share is satisfied. In this setup the Senior TVS has 30% value share claim, or $11.22 minimum value share, Junior TVS has 25% value share claim, or $9.35 minimum value share if the Senior TVS is satisfied, and so on. 

Based on the monthly performance of GE stock, assessed for the period of 01/01/2007-01/12/2017, the following results can be observed: 

  • TVS Senior was the only value tranche that never reached a value of zero, thus from time to time having a value equal to the value of underlying, during the times of severe price declines in GE stock, when the other value tranches exhibited a value of zero, which is also evident from the TVSs’ attachment and detachment points, that indicate that for TVS Equity in order to decline in value, a decline in value of GE stock of any value greater than zero is enough, while in order for it to have value completely wiped out, a decline of 10% is required, while for TVS Senior, a decline of at least 70% is required in the value of GE, in order to start reducing its minimum value, and a decline of 100% of GE stock is required, to wipe out all value of the tranche. 

  • TVS Equity has the highest number of value defaults, amounting to 89% (in fact this value tranche reached a value of zero at 01/05/2008 and hasn’t recovered until the end of the assessed period).

  • Return profiles of all securities display a highly volatile performance, some of the return values reaching values above 100% and -100%, which indicate significantly magnified performance of the underlying GE stock.

  • Return distributions of all value tranches indicate significantly changed shapes, while the original distribution of GE was somewhat normal, all securities except for GE and TVS Senior have a significant number of returns outliers, in some cases having significantly extreme values amounting to nearly 40.0x of monthly return. 

  • Return distributions of all value tranches, except for TVS Equity exhibited either slightly positive, either extreme positive excess kurtosis, while GE stock had a negative excess kurtosis. 

  • All securities, except for the underlying stock and TVS Senior, had positive skewness. 

  • Return correlations between the underlying was the lowest with TVS Junior (3rd most junior value tranche) and TVS Senior, while correlations between TVS Junior, TVS Mezzanine (2nd most junior value tranche) and TVS Equity with TVS Senior, and TVS Subordinated (2nd most senior value tranche) were nearly zero.

  • Beta coefficient for GE was 1.10x, which was transformed to 0.99x in TVS Senior, 1.65x in TVS Subordinated, -0.78x in TVS Junior, -0.15x in TVS Mezzanine, and 4.81x in TVS Equity, while the weighted average for all TVSs is reduced to 1.01x. 

More details of the potential securities issuance with other underlyings can be found in the original manuscript, but all the tests conducted suggest significant transformation of underlying security performance, providing diversification benefits in various market states and satisfying a wide range of investor desired risk-return profiles.

Tranched Value Securities present a new phase in financial market innovation with their unique feature of individual asset performance segmentation and transformation, in some cases, reaching as far as transformation of the underlying asset class from equity to debt, and vice versa, while providing other corresponding benefits typical to other derivatives, such as improved leverage use, diversification, exposure to new investment opportunities, and hedging prospects. While successful launch and implementation of TVS requires further work to be done in order to minimize possible risks and cases of misuse, which happened with other derivatives before, together with coordinated work of market participants, only the time will show the effects of Tranched Value Securities on market efficiency and asset price discovery.

We are excited to reveal some of our upcoming developments and we hope you will join us on this journey.

To learn more about Tranched Value Securities, sign up for email updates on our website. To stay up to date on Alter Securities news and announcements, follow us on LinkedIn, Twitter, Facebook, or Instagram.

This post appeared originally on LinkedIn.

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