Wednesday, October 10, 2012

The Big Short (Vol) Trade

Perhaps a (very bad) idea whose time has come, at least to give it a thought

Historically, selling far OTM options has been branded as a reck-less trade, especially in this post-Lehman markets obsessed with swans of the black variety in particular. But the chart below put things in a slightly different perspective

Assume a position where we sell a covered far OTM swaption payer (or receiver) spread. So we set aside an amount for the maximum loss arising out of the position. Such a position can be compared to a long bond position - we can imagine the sum set aside as an investment in the bonds and the premiums we receive as coupons. The event of the option spread getting exercised is similar to a default event. Assuming a standard 40% recovery, we can compute the yield of the equivalent bond position as 

yield = premium/(max loss/60%)

The above plot compares these yields on these imaginary bond-like positions (let's call them "Coins in Front of Road Rollers" bonds, or CFRR for short)  with bunds and BBB corps. Pre 2008 it was indeed a reck-less idea, the yields on these CFRR bonds are on an average much lower than the even the high quality bunds yield. But then something changed in 2008. With yield hitting the Zero Lower Bound (ZLB), the investors has chased down the yields on the so called High Yield (HY) bonds as well. The upside in bonds are limited with considerable downside. Not very much unlike a short vol trade. And these CFRR yield does not look so ugly now in the plot.

Fast monies and smart real monies chasing yield, and credit funds as well, should take a note of this fact. Putting money into HY to boost portfolio yield is not fundamentally very much different than selling OTM rates options. Given the current centrally administered markets with converging correlations, the default risk of a junk bond is marginally different than a massive move in rates (which will force many firms to default anyways)

On the flip side of this - those looking for BUYING far OTM options, an interesting area to look in to, I think, is far OTM 6 month LIBOR or 12 month LIBOR interest rates caps vs swaptions - less as a wedge trade and more to trade the regulatory risk of a reform of fixing submission method and consequent potential of much upward fixings for un-collateralized lending rates, if the current scenario persists

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