Date of Award

Fall 11-2006

Document Type

Thesis - Open Access

Degree Name

Master of Business Administration in Aviation

Department

Aviation Business Administration

Committee Chair

Vitaly S. Guzhva

Committee Member

Vedapuri Raghavan

Committee Member

Vladimir V. Golubev

Abstract

The airlines have enormous needs for capital. Historically, capital spending was accountable for about 15 percent of annual airline revenues, more than double the average for manufacturing companies (Arpey, 1995). Access to capital is essential to the long-term viability and growth of the airline industry especially due to the capital-intensive nature of its business. However, highly cyclical nature of the airline business and its severe dependence on general economic condition make investments in the industry risky and uncertain. The airline's junk bond credit rating and enormous amounts of debt result in extremely high costs of capital. In addition, the airlines find very difficult to raise funds on equity markets since investors are not impressed with poorly performing airline stocks. To satisfy their needs for capital the airlines have turned towards convertible securities. The important feature of convertibles is the relative insensitivity of their value to the risk of the issuing company (Brennan and Schwartz, 1988). This separation is achieved by selecting appropriate convertible contract parameters.

Pricing of interest rate derivatives and instruments with embedded options, such as callable convertible bonds and preferred stocks, is typically performed utilizing models of the term structure of interest rates. Ramanlal, Mann, and Moore (1998) test several contingent claims valuation models adapted to callable convertible preferred stocks. Based on their large scale testing, the best performing valuation model produced mean pricing errors of about -0.18%. In this study this model is utilized to assess market valuation of airline convertible preferred stocks.

The sample consists of 11 convertible preferred stocks issued by U.S. airlines in 1980 - 1991. For each convertible daily model prices are estimated for two years after issuance and compared with market prices by calculating pricing errors. It turns out that mean pricing error for our sample is 2.63 %, indicating that market undervalues airline convertible preferred stocks by about 2.63 %. In addition, a panel data analysis of pricing errors suggests that market undervaluation in much more severe immediately after issuance and persists for approximately 6 months. The mean pricing error for a subsample containing first six months of daily prices is 8.01 %, while for a sub-sample of convertible daily prices for 7-24 months after issuance the mean pricing error is 0.10 %.

There are two potential explanations of observed discrepancy between market and model pricing of airline convertibles shortly after issuance: model mispricing or market undervaluation. Since utilized model was extensively tested and found to be superior in pricing convertible preferred stocks market undervaluation seems to be a plausible explanation. Pricing model cannot capture investor sentiment towards traded securities. Probably, market perception of airlines as higher risk companies, influences prices of newly issued convertibles. However, in about six months of trading, the insensitivity of properly designed convertibles to the risks of issuing companies becomes obvious and the market and theoretical values of convertibles converge. Market undervaluation of airline convertibles at issuance suggests that, probably due to their reputation, airlines cannot efficiently raise capital even with convertibles.

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