An Auction Rate Security (ARS) is a debt security that is sold through a Dutch auction. The ARS is sold at an interest rate that will be as low as possible, but still high enough to sell all available units of the security. The final interest rate, also known as the clearing rate, is then paid on the total face value of the security. The key feature of auction rate securities is that they reset at frequent intervals, thus allowing investors the flexibility to adjust their fixed incomes.
1. What is a Dutch auction?
A Dutch auction is a type of public offering where the price of an item is lowered until it receives a bid. The first bid made is the winning bid and results in a sale, assuming that the price is above the minimum bid price.
2. How does ARS offer the flexibility to adjust fixed incomes?
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In an ARS, the interest rate resets at regular intervals, typically every 7, 28, or 35 days. This resets give investors the opportunity to either hold the security and earn interest at the new rate or sell it at auction.
3. What is the clearing rate in auction rate securities?
The clearing rate is the lowest interest rate at which all the available units of an ARS can be sold at auction.
4. Does ARS have any risks?
Yes, they do. If there are no buyers in the auction, the existing holders must hold the securities until the next auction, and they may receive a lower than expected rate of return. Another risk is that the overall creditworthiness of the issuer may decline, leading to a lower price for the ARS.
5. Can ARS be converted to other securities?
ARS cannot be converted to other securities. Once purchased, the investor has to wait until the next auction to sell the securities.