Auction Rate - Explained
What is an Auction Rate?
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Table of ContentsWhat is an Auction Rate?How Does an Auction Rate Work?Limitations to Auction Rate BiddingAcademics Research on Auction Rate
What is an Auction Rate?
An auction rate refers to the interest rate payable on debt security as determined by the Dutch auction process. Auction rate securities are debt securities traded through a dutch auction and have a long-term maturity which attracts interest rate payments as set by the Dutch auction process. A dutch auction is a form of public offering in which the price of the offering is determined after all bids have been made. The price is set based on the highest bids. The auction rate is regularly reset, usually when there is another such auction.
How Does an Auction Rate Work?
The auction rate also determines the interest rate on Treasury securities, it is sometimes applied to municipal bonds and other debt securities. The Dutch auction process is just a typical auction whereby investors place a bid for the number of debt securities they seek to purchase. The interest (auction) rate for specific security is thereafter fixed considering the bids of the investors. Auctions can take place weekly, monthly quarterly or annually as the needs arise. Through the auction rate, the issuer of debt securities and the investors purchasing them can determine their cost and returns. Although auction rate changes from time to time, they are less volatile than other interest rates, reducing the level of risk in an investment. Auction rate securities are variable rate bonds that can be purchased on a Dutch auction. Although long-term bonds, these securities have short-term interest rates. For investors, auction rate securities help to mitigate investment risks and the interest rate can either be taxable or tax-exempt. Issuers of auction rate securities derive certain benefits from the securities, such as access to lower-cost financing through mass participation of investors in the auction.
Limitations to Auction Rate Bidding
There are certain limitations or drawbacks specific to the Dutch auction, this is aside from the 2008 situation where most auctions failed woefully and the general auction market was affected. The limitations of the Dutch auction include the following;
- The auction is exposed to a limited number of investors interested in buying the securities put up for a bid. The number of investors is insufficient for the number of securities up for bid.
- In a dutch auction, there is no guarantee that bidders will show up, and this creates problems for the issuer.
Academics Research on Auction Rate
- Dutch auction rate preferred stock, Alderson, M. J., Brown, K. C., & Lummer, S. L. (1987). Dutch auction rate preferred stock.Financial Management, 68-73. Corporate cash managers have developed a number of equity-based strategies designed to utilize the partial tax exclusion for dividend income. A problem that has been common to all of these investment programs, to various degrees, is the need to protect invested principal. This paper examines a recent innovation in the area of corporate finance and cash management, dutch auction rate preferred stock (DARPS). Specifically, a sample of 201 dutch auction outcomes is empirically examined. The results demonstrate that DARPS issues provide a superior after-tax return relative to commercial paper and Treasury bills. Further, yields are shown to be set such that the tax benefits of the dividend exclusion are shared between the issuing and purchasing firms.
- Auction failures and the market for auction rate securities, McConnell, J. J., & Saretto, A. (2010). Auction failures and the market for auction rate securities.Journal of Financial Economics,97(3), 451-469. The market for auction rate securities (ARS) made headlines during the second week of February 2008 when auctions at which the bonds interest rates reset experienced a wave of failures. Contrary to headlines that attribute the failures to a frozen market or investors irrationality, we find that (1) even at their height, less than 50% of ARS experienced auction failures, (2) the likelihood of auction failure was directly related to the level of the bonds maximum auction rates, (3) the implied market clearing yields of bonds with failed auctions were significantly above their maximum auction rates, and (4) ARS yields were generally higher than yields of various cash equivalent investment alternatives. We infer that investors priced the possibility of auctions failures into ARS yields and rationally declined to bid for bonds for which required market yields exceeded their maximum auction rates.
- Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia., Aron, J., & Elbadawi, I. (1992). Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia. Zambia's failure with macroeconomic reform - including exchange-rate reform - is the result of macroeconomic (especially fiscal) laxity. And the exchange-rate premium is likely to rise as terms of trade worsen, foreign aid declines, and expectations of devaluations rise.
- Auction institutional design: Theory and behavior of simultaneous multiple-unit generalizations of the Dutch and English auctions, McCabe, K. A., Rassenti, S. J., & Smith, V. L. (1990). Auction institutional design: Theory and behavior of simultaneous multiple-unit generalizations of the Dutch and English auctions.The American Economic Review,80(5), 1276-1283.
- The fragility of discretionary liquidity provision-lessons from the collapse of the auction rate securities market, Han, S., & Dan, L. (2010). The fragility of discretionary liquidity provision-lessons from the collapse of the auction rate securities market. We study the fragility of discretionary liquidity provision by major financial intermediaries during systemic events. The laboratory of our study is the recent collapse of the auction rate securities (ARS) market. Using a comprehensive dataset constructed from auction reports and intraday transactions data on municipal ARS, we present quantitative evidence that auction dealers acted at their own discretion as "market makers" before the market collapsed. We show that this discretionary liquidity provision greatly affected both net investor demand and auction clearing rates. Importantly, such discretionary liquidity provision is fragile. As auction dealers suffered losses from other financial markets and faced increasing inventory pressure, they stopped making markets. Moreover, the drop in support occurred suddenly, apparently triggered by the unexpected withdrawal of one major broker - dealer.