Is this arb (a free option on top of a perpetuity)?

Buy one of these: http://www.citigroup.com/citigroup/press/2008/080117c.htm for $52.00 Sell a C '10 35 Call @ 2.00. Discuss… (Note: this is clearly not pure arb, but are the risks material?)

Discuss- Well, commen sense can tell you there is risk. You are earning more than the risk free rate, and there is no guarentee of a payment, therefore the risks are material. This was a 10 second analysis.

Well, from a textbook perspective there are tons of risks you could point out. I meant practically; for instance, would you really be worried about Citi not paying a dividend? Is the credit of a commercial bank of that size really that different from the credit of the federal government?

“Is the credit of a commercial bank of that size really that different from the credit of the federal government?” If that’s your investment thesis, then just buy Citigroup bonds. Presto Chango, you increased your “risk free” rate by about 1.5%.

Whoa - (but note that I have no opinion on these particular securities) Seems to me that there was a discussion on GD about Citibank going bankrupt or requiring a government bailout. It’s hard to imagine a govt bailout while they are still paying non-cumulative preferred dividends. So, yes, the answer is the non-cumulative preferred stock from Citibank has oodles more credit risk than US Govt T-notes. It’s not even in the same universe. A few other observations - a) Preferred stock is not a perpetuity. A perpetuity is a bond and higher on the corporate food chain than preferred stock. If Citi has money troubles, they can just stop paying dividends on the preferred with no dire consequences. b) The cash flows from this preferred stock are much different than a perpetuity. Within 2013 or a couple of years thereafter, the story on this preferred will be told and over. Either Citi will have solved their problems and the preferred will be called or they won’t and the preferred will be in a very bad way. A perpetuity will keep paying coupons year after year as long as the company can still make payments. The farther you go out into the future the fewer are the (equity return, equity vol) paths that keep this preferred alive and paying dividends. c) Call options (as you want to short in your “arb”) and embedded exchage warrants in the convertible preferred are quite different. One implies exchanging cash for the stock, the other offers to exchange preferred stock whose value is highly correlated with the value of common for the stock. There is no reason to believe that anything about those two should be the same. d) There is a date mismatch in your arb e) You have sold the company a call not accounted for in your arb. Edit: The last sentence in c) is too extreme.

JoeyDVivre Wrote: ------------------------------------------------------- > Whoa - (but note that I have no opinion on these > particular securities) > > Seems to me that there was a discussion on GD > about Citibank going bankrupt or requiring a > government bailout. It’s hard to imagine a govt > bailout while they are still paying non-cumulative > preferred dividends. So, yes, the answer is the > non-cumulative preferred stock from Citibank has > oodles more credit risk than US Govt T-notes. > It’s not even in the same universe. > > A few other observations - > > a) Preferred stock is not a perpetuity. A > perpetuity is a bond and higher on the corporate > food chain than preferred stock. If Citi has > money troubles, they can just stop paying > dividends on the preferred with no dire > consequences. > > b) The cash flows from this preferred stock are > much different than a perpetuity. Within 2013 or > a couple of years thereafter, the story on this > preferred will be told and over. Either Citi will > have solved their problems and the preferred will > be called or they won’t and the preferred will be > in a very bad way. A perpetuity will keep paying > coupons year after year as long as the company can > still make payments. The farther you go out into > the future the fewer are the (equity return, > equity vol) paths that keep this preferred alive > and paying dividends. > > c) Call options (as you want to short in your > “arb”) and embedded exchage warrants in the > convertible preferred are quite different. One > implies exchanging cash for the stock, the other > offers to exchange preferred stock whose value is > highly correlated with the value of common for the > stock. There is no reason to believe that > anything about those two should be the same. > > d) There is a date mismatch in your arb > > e) You have sold the company a call not accounted > for in your arb. > > Edit: The last sentence in c) is too extreme. Fair enough, I’ll concede that it’s not a perfect arb and there’s risk. However, how well could you create one by shorting stock? "Seems to me that there was a discussion on GD about Citibank going bankrupt or requiring a government bailout. It’s hard to imagine a govt bailout while they are still paying non-cumulative preferred dividends. So, yes, the answer is the non-cumulative preferred stock from Citibank has oodles more credit risk than US Govt T-notes. It’s not even in the same universe. " Been more talk recently about Bernanke printing cash… What’s worse US Refi risk or C? Would one truely go default without the other? It’s kind of irrelevant, but who are the other central banks incresing their allocations to? "b) The cash flows from this preferred stock are much different than a perpetuity. Within 2013 or a couple of years thereafter, the story on this preferred will be told and over. Either Citi will have solved their problems and the preferred will be called or they won’t and the preferred will be in a very bad way. A perpetuity will keep paying coupons year after year as long as the company can still make payments. The farther you go out into the future the fewer are the (equity return, equity vol) paths that keep this preferred alive and paying dividends. " That’s fair enough, but back to my original statement here, the paths are all a function of common stock in the end. How easily is this hedgable with short stock? "c) Call options (as you want to short in your “arb”) and embedded exchage warrants in the convertible preferred are quite different. One implies exchanging cash for the stock, the other offers to exchange preferred stock whose value is highly correlated with the value of common for the stock. There is no reason to believe that anything about those two should be the same. " Of course there’s a difference, but 1) the perferred stock is always convertible, so you are always effectively long a call option and 2) your long “call” from the preferred is in the money if your short call is ITM, so you’re effectively hedged. I guess my point behind all of this is that the optionality looks absurdly cheap. I mean, it seems (based purely on my gut, no calulations) that the embedded call is cheap enough to make you long gamma despite the expiry differences… Sure you can make credit arguments but I don’t think the problems are substantial enough to require something like CDS, and would be pretty easy to cover on your own. If you were going to take advantage of the free optionality, you’d need to be short the stock anyway… As to their short option, it seems like you’re selling them the time period which will, most likely, take place after the $h!t hits the fan, while you’re long vol, albeit capped to an extent, through all the drama. Am I way off here?

Again, I don’t have any opinion on this security and it is oversubscribed. Maybe the optionality is cheap. Hedging credit risk with CDS is overhedged on the credit side because this is cheesy preferred stock with a nice option. If you think that Citi is not a credit risk, there are gajillions of securities out there that you would find attractively priced.

JoeyDVivre Wrote: ------------------------------------------------------- > Again, I don’t have any opinion on this security > and it is oversubscribed. Maybe the optionality > is cheap. Hedging credit risk with CDS is > overhedged on the credit side because this is > cheesy preferred stock with a nice option. > > If you think that Citi is not a credit risk, there > are gajillions of securities out there that you > would find attractively priced. I hear you, and believe me, I would buy them if I could…

I’m actually more on your side with the market call than my posts might indicate, but I think the preferred stock is probably not the way to go. While I’m not going to do a research project on Citi right now, I think it’s long-term prospects are very good becaue it’s an institution that is nearly necessary for global economic functioning. If you were going to finance a diamond mining operation in Ghana and buy mining stuff from Germans and Mexicans, who would you go to?

Joey, I think you agree with me. If you think Citi is too big to fail, buy a bond. You say “I would buy them if I could”… is there some reason you can’t buy a Citi bond?

newsmaker Wrote: ------------------------------------------------------- > Joey, I think you agree with me. > > If you think Citi is too big to fail, buy a bond. > You say “I would buy them if I could”… is there > some reason you can’t buy a Citi bond? yep… not going into any more detail… Just wanted to talk about a trade I wish I could do… Also, doing this would involve, some (if not full) hedging of actual exposure to C common, so the “If you think Citi is too big to fail, buy a bond.” reasoning isn’t exactly what I’m getting at here…

ahahah Wrote: ------------------------------------------------------- > That’s fair enough, but back to my original > statement here, the paths are all a function of > common stock in the end. How easily is this > hedgable with short stock? > That’s a pretty good research question - I wouldn’t do it with just short stock but some combination of CDS and short stock would be interesting.

JoeyDVivre Wrote: ------------------------------------------------------- > ahahah Wrote: > -------------------------------------------------- > ----- > > > That’s fair enough, but back to my original > > statement here, the paths are all a function of > > common stock in the end. How easily is this > > hedgable with short stock? > > > That’s a pretty good research question - I > wouldn’t do it with just short stock but some > combination of CDS and short stock would be > interesting. Well that question is the foundation of this thread (maybe I didn’t communicate it effectively…). Could you isolate the embedded long call in the preferred without using CDS? How much of a proxy hedge is it really? In the case of something like this where you’re talking about a high-grade borrower, is the correlation between credit and common high enough to be inter-changeable? I think that due to liquidity and the basic nature of the product, I don’t think this works if you have to use CDS, but I think you can make it work with strictly short stock… Although I’m not sure about CDS, could you get more leverage if you bought them? Probably not because I’m sure clearing wouldn’t link the Preferred to FI credit risk… Gotta love risk management…

Is there some question here that needs to be taken offline? I get the feeling more is going here than just a chat.

Who knows… sometimes I just start running my mouth and random sh!t spews out

sh!t spews ut of your mouth? That’s really gross.

JoeyDVivre Wrote: ------------------------------------------------------- > sh!t spews ut of your mouth? That’s really gross. yeah, it’s a big problem… very tubgirl.com-esque… If you want to chat about this more, send me a pm on the other site. I’m leaving at about 12:30 or one today though so I may not get back to you for a bit…