Old Bank of England Working Papers

These are my old WPs that are no longer available on the Bank of England website and are not published elsewhere. I sometimes (rarely to be honest) get requests for these

Working Paper No 14 , 1993
“House prices, arrears and possessions: A three equation model for the UK”
by F J Breedon and M A S Joyce 

The current slump in the UK housing market has coincided with record increases in mortgage arrears and possessions. Falling nominal house prices reduce the amount of unwithdrawn equity in housing and, under certain conditions, provide incentives for borrowers to accumulate arrears and for lenders to possess. However, possessions may themselves depress house prices. This paper attempts to analyse and quantify these interactions by estimating a three equation econometric model of UK mortgage arrears, possessions and house prices, in which expectations of future house prices are formed according to the rational expectations hypothesis. The model is simulated to examine the implications of interest rate changes and policies to reduce possessions.

Working Paper No 39,  1995
“Valuation of underwriting agreements for UK rights issues: evidence from the traded option market”
by Francis Breedon and Ian Twinn

A recent study by Professor Marsh of the London Business School has estimated that sub-underwriters of rights issues (firms that commit to buy up any remaining shares at the end of a rights issue) make an excess profit of 86% of the fee they charge. Because of this study, the OFT (who originally commissioned it) have argued that underwriting is too expensive and have encouraged firms to reconsider their issuance techniques.

Marsh's study, however, is based on a number of assumptions that are unlikely to hold in practice. In particular, Marsh used the Black and Scholes option pricing formula to value the economic cost of underwriting (underwriting is like a put option since it gives the firm the right but not the obligation to sell shares to the underwriter). But it is well known that the Black and Scholes formula is based on a high unrealistic view of financial markets with no transactions costs and no information asymmetries.

To make a more realistic estimate of the economic cost of underwriting, this paper looks at the cost of buying put options in the traded option market. This does not mean that buying a put option in the traded option market is a viable alternative to underwriting it simply allows for a more realistic measure of transactions costs. By looking at the price of put options on firms who have just announced a rights issue the paper funds, unsurprisingly, that the true cost of put options was much higher than the Black and Scholes formula predicted. However, it still found that underwriters made an abnormal profit, even if it was only 40% of the fee rather than 86%.  

Working Paper No 57, 1996
“Why do the LIFFE and DTB bund futures contracts trade at different prices?”
Francis Breedon

The German Bund futures contract is the most important bond futures contract in Europe. It is also unusual in that it trades on competing Exchanges - LIFFE in London and the DTB in Frankfurt. This paper looks at a surprising aspect of this dually traded contract, namely that the contract trades slightly more expensively (1.5 basis points) in LIFFE than in the DTB. LIFFE argue that this price difference helps make their contract more attractive.

The paper investigates three possible explanations for the price difference. First, the calculation of price factors (conversion factors that make bonds in the basket of deliverables more comparable) differs slightly between Exchanges. Second, the DTB contract carries on trading for one day longer than the LIFFE one giving the short one more days to choose which bund in the basket to deliver (the so-called quality option) and so makes the contract slightly less valuable to the trader with a long position. Third, the penalty for late delivery is harsher on LIFFE than on the DTB and so investors fearing a short squeeze (where investors that are supposed to deliver the underlying bunds cannot acquire them) will be more nervous of holding a LIFFE contract than a DTB one.

It concludes that none of these factors are important enough to explain the observed price difference and so it is hard to explain why the price difference occurs.