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New Essay: Cost of Leverage


racemize
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Hi all, I've been working on this essay for several months now, and after a grueling editing process, I think it is ready for prime time.

 

Many of you probably recall the extended conversations between Eric and various other board members trying to understand how to calculate Cost of Leverage (particularly when dividends were involved) and the behavior of Cost of Leverage over time.  I tried to cover both of those topics in the essay.

 

Thus, the initial part of the essay is how to calculate the Cost of Leverage for loans and calls (with and without dividends, multiple ways), and the second part discusses how the Cost of Leverage changes over time.  If you already know how to calculate Cost of Leverage, then you can skip down to the second part, which has pretty graphs.  Before starting out, I hadn't realized how strong the curve fit was.  Anyway, take a look:

https://www.dropbox.com/s/u3epy2qiepi9odr/2016-10-11%20Cost%20of%20Leverage.pdf?dl=0

 

Incidentally, after staring at and trying to explain Eric's formula for several hours, I realized it could be expressed almost the same as Greenblatt's formula, that many folks already used.  In doing so, you can see that Eric's adjustment is actually quite simple (replace strike price with (share price - call price).  Anyhow, no one probably cares about that, but I had to pull out some algebra substitutions to make it happen (you know that cool 1/1 can be anything you want trick).

 

Finally, this was posted a long time ago, but I did create a spreadsheet that keeps track of the CoL for almost all the TARP warrants, which can be found here:

https://docs.google.com/spreadsheets/d/1NUVie3jKSM64ow9td9-cU-GBFkf5atgeOoTT1aiLtOo/edit?usp=sharing

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