Simulations

The Necessity for Simulations

As has been discussed in the Overview of Valuation, there are many measures of valuation used to estimate the relative value of each preferred share issue examined in the universe. There are also a great number of factors that are related recommendations for possible preferred share swaps, as discussed in the Overview of Trading.

Hymas Investment Management Inc. takes as its core analytical philosophy the concept that one must never be doctrinaire in analyzing any financial market. It is not the job of the analyst to determine what the market should do; it is his job to determine what the market is likely to do. Thus, whenever a potential method for determining valuation and trade recommendations is hypothesized, it must be tested against data over a wide range of market conditions; the hypothesis must also be examined to determine whether it makes sense.

The determination of whether a hypothesis "makes sense" can, if taken to extremes, lead to a dogmatic approach to financial market analysis. One could potentially discard all hypotheses which do not fit into a rigid theory of capital markets without testing them - a form of intellectual dishonesty which must be shunned at all costs. However, openness towards consideration of new ideas and a thorough analysis of instances in which a particular market theory breaks down can go a long way towards improving ones understanding of price changes in any capital market. On the other hand, the requirement that a hypothesis "make sense" can avoid artefacts due to insufficient data; one could well imagine, for instance, that a particular data set could provide support to a hypothesis that stocks with a trading symbol comprised of eight characters should be purchased on Wednesdays and sold on Fridays; but since this particular hypothesis cannot be explained in terms comprehensible to a prudent and rational investor it should not be tested.

Any hypothesis proposed must have an explicable rationale; all such hypotheses should be tested against historical data to ensure that the logic does, in fact, have a reasonable probability of predicting the future.

Historical Data Used by HIMIPref™

The following data is used to test the relative value of all hypotheses proposed in evaluating preferred shares:

• Closing Bid Price
• Closing Ask Price
• Traded Volume
• Dividend ex-date
• Dividend Record Date
• Dividend Pay Date
• Dividend Amount
• Credit Ratings

Proposed analytical methodologies are run over a test bed of these data from December 31, 1993 to the most recent month-end.

Methodologies

There are two methodologies used in evaluating hypotheses: the "Portfolio Method" and the "Issue Method".

Portfolio Method

The "Portfolio Method" commences a simulation with a constant amount of cash; different simulation runs can vary this amount of cash to test the possibility that volume restrictions on trading lead to different trade recommendations based on account size. A small account, for instance, might be able to take on and reverse positions more easily than a large account, leading to an increased emphasis on short-term capital gains.

In the "Portfolio Method", allowance is made for the periodic payment of income and capital gains taxes, according to an exogenous tax rate - the more realistic a simulation is, the more likely it is to have future validity. Additionally, it is assumed that the performance of the portfolio will be judged by clients in terms of how well it performs relative to an index and there are constraints imposed on the simulation scoring to reflect the idea that, in practice, risk is regarded on an asymmetric basis - relative underperformance, especially for an extended period of time, is severely deprecated.

The portfolio:

• trades in accordance with its simulated position: shares are acquired with the initial cash and only these positions (and those subsequently assumed through purchase) may later be traded
• trade volumes are constrained by the actual historical trading volume of the security
• Purchases are presumed to be executed at the ask price, sales at the bid
• Exogenously imposed commission rates are applied to each transaction
• Parameters are varied to maximize the "Simulation Score", a number that attempts to measure the satisfaction of the client with the portfolio performance relative to an index.

Issue Method

The "Issue Method" is intended to be more applicable for purposes of research into individual valuation and trading factors and for use by smaller portfolios in which there is insufficient diversification to make a comparison to an index meaningful. The objective is to determine how to recommend preferred share swaps to maximize the chance that a recommended trade will be profitable.

In this methodology:

• Issues with reasonably high levels of valuation are compared with each other and a determination made as to whether, given current parameterization, a trade is to be attempted.
• The position is maintained until the "closing date". The "closing date" is defined as the first day on which a recommendation is made to sell the issue purchased in order to buy an issue that was not so recommended on the opening date.
• A determination of the profitability of each recommended trade is made. Shares are sold at the bid, purchased at the offer, and there is full allowance for exogenously defined commissions and tax schedules.
• Parameters are varied so as to maximize total profitability.