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.
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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.