Rational Ideas for an Irrational World
Introduction:
Notwithstanding the uncertainty of what will be the “next shoe to drop”, today’s
market is fundamentally different than that of 1998 (LTCM/Russian Crisis). This
RateLab will focus on ideas that can rationally reduce your risk. That does not
mean they will produce significant positive returns (alpha) on a stand alone
basis. What it does mean is that they will reduce the variance risk of a position
that is already overly exposed to credit risk and needs to be controlled. Most
critical, the transactions below will not make your situation worse than it
currently might be by introducing additional vectors of variance. As such, most
of these trades will involve some sort of long options position to create a limited
loss/unlimited return profile. Moreover, it will focus on correlations that are
reasonable in today’s environment.
First and foremost, unlike 1998, most market participants are NOT short
Treasuries versus MBS, CMBS, Corporates or Swaps. As such, buying T10s (or
some other form or duration) is adding risk (i.e., line items) to portfolios, not
reducing risk. Second, buying the curve in the cash, futures or swaps markets as
a proxy for the FED coming to the rescue sooner than expected is also a suspect
strategy since the balanced payoff profile does not offset the asymmetric risk
profile of a long credit position. Finally, hedges that rely on the “greater fool”
theory should be avoided if they do not “foot” to the fundamental risks of your
positions. Consequently, we do not recommend shorting high grade credit index
products where the underlying asset is “money good” while your exposure is in
lower grade credit products that may be “money bad”.
You can summarize our recommendations below via the not quite accurate but
nonetheless commonly accepted Hippocratic Oath: “First, do no harm.” We
believe these ideas will allow you to ride out this most recent version of the
“Hundred Years Flood”…….that just seems to occur every four to seven years !
1
Rational Ideas:
The FED will ease ideas:
1) Buy calls on the FED Funds contracts
December 2007 Fed Funds contract at 95.06 (4.94%)
Mid-market on the 12/31/07 expiry 95.00 (5.00%) calls @ 17bp
That is an 11.35% Yvol or a 56bp Nvol
Breakeven: Average December Fed Funds rate of 4.83%
Bloomberg symbol: FFZ7 commodity OHT12
2) Buy calls on EDZ8, the December 2008 Eurodollar future
December 2008 Eurodollar contract at 95.15 (4.85%)
Mid Market on the 12/15/08 expiry 95.00 (5.00%) call @ 48.5bps
That is a 18.8% Yvol or a 92.6bp Nvol
Breakeven: 3m-Libor at 4.515% for December 15, 2008 setting
Bloomberg symbol: EDZ8 commodity OHT12
Comments: For the record, we do not believe the FED will ease before the First
Quarter of 2008 unless there is a precipitous decline in the economy. This would
include: a) the Dow/S&P setting new calendar year lows of below 12,000/1400;
b) an unemployment rate above 5.0% or non-farm payroll negative for at least
two consecutive months; c) ISM below 50 for three consecutive months; d) a
major financial firm seeking bankruptcy protection. All of these seem quite
unlikely given the most recent data on the economy and corporate
profits/balance sheets. Nonetheless, further losses in credit products will
certainly have a real correlation with the economy doing worse. As such, these
trades make sense. The critical concept is utilizing options to create a limited
loss situation if the worst does not occur. Short rates have declined by over
60bps; a patient FED and stable equity market will create losses greater than
your credit gains for those who are “straight long” the front-end of the rates
market. Although Implied Volatility is certainly much higher now than a
month ago, it is still below the ten year average for similarly structured
options. These trades are the most direct way to use the rates market to
hedge credit risk; all other transactions are just secondary effect transactions to
the FED easing in response to a financial markets seizure.
2
The Curve will steepen ideas:
3) Buy cap options on the Yield Curve
CMS 10s minus CMS2s, Two year expiry; single look; $10,000 per bp payout
Spot spread = +39.7bps; Forward Strike = +44.9bps
Price = 24bps; Implied Spread Vol = 47bp;
Breakeven: +68.9bps
4) Buy straddles on the 2 year rates vs. Sell straddles on the 30 year rate
Buy 759mm 2yr into 2yr atm straddles at 184.5bp; 96.5 Nvol; k = 5.248%
Sell 100mm 2yr into 30yr atm straddles at 1100.0bp; 75.7 Nvol; k = 5.721%
Nvol ratio of 127.5%
3
Comments: Similar to the previous ideas, if financial conditions significantly
worsen, the market will lead the FED to an ease and the Yield Curve should
steepen. Our preferred strategy is to use options to gain this exposure. Yield
Curve options are still quite inexpensive due to the massive supply via the
Structured Note market. With a terminal breakeven barely 29bps steeper than
current spot levels, this trade provides a tremendous risk/return profile. The
second trade is a tad more complicated. As highlighted in the chart above, the
Implied Volatility of 2year tails is usually much higher than that of 30year tails.
Massive Structured Note issuance in 2004 and 2005 combined with a transparent
and measured FED pressed this ratio to its all-time low. The uncertainty that
current conditions have introduced to the market will expand this ratio no matter
what happens. Over the past month alone, the Actual Volatility ratio has realized
142%, almost 13% greater than the current entry level. Moreover, if this does
prove to be a false alarm, the Curve Gamma profits created from a large
flattening will offset much of the Vega losses that would accompany it.
Volatility as an Asset Class trades:
5) Buy the Merrill Lynch Implied Volatility Swap on 5yr into 3yr
Ten year term; Semi annual pay; (details in RateLab April 10, 2007)
Spot price of 348bps or 92.9Nvol; Fixing of 344bps
ATM Premium Lock-in level 5y3y ATM BPVol (RHS)
700 160
600 140
120
500
100
400
BPS
BPS
80
300
60
200
40
100 20
0 -
5
7
-9
-9
-9
-9
-9
-0
-0
-0
-0
-0
-0
-0
-0
ry
ry
ry
ry
ry
ry
ry
ry
ry
ry
ry
ry
ry
a
a
nu
nu
nu
nu
nu
nu
nu
nu
nu
nu
nu
nu
nu
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
Ja
4
5y3y Statistics
MAX 576 141.7
95th %le 512 128.7
84th %le 467 123.1
Average 396 107.8
16th %le 340 92.8
5th %le 301 81.3
Min 275 75.8
Std Dev 62 14.2
Current % 18.36% 14.14%
Correl 93.3%
Comments: Not much to add beyond our April 10, 2007 RateLab: “Building a
Superior Volatility Mousetrap”. The only difference now is that we are
recommending the 5yr-3yr point on the grid instead of 5yr-5yr. This “box” is still
below the 20th Percentile. (See charts above) Moreover, the shorter-tail will
outperform in a financial panic.
6) Buy a Forward Starting Variance Swap on the S&P
Similar in construct to the above, except driven by Implied Volatility on the S&P;
Five months forward (Dec 2007 CME date) for Three months (Mar 2008 CME
date). Offered at a 21.2% volatility.
5
Comments: Similar to the ML Implied Volatility Swap above. You are NOT
buying the Realized Volatility of the S&P via the standard variance swap format;
you are buying the Implied Volatility forward. As such, there will be no gamma,
theta, delta, or skew maintenance. You are basically buying the three month
VIX starting at year end. As such, Realized Volatility may be below your level
but if financial panic has not abated, Implied Volatility could be much higher.
Contagion into the Domestic Economy trades:
7) Buy puts on the S&P equity futures
December 2007 S&P contract at 1479.6
Mid Market on the 12/21/07 expiry 1475 put is 67.5 dollars
That is a 19.7% Implied Volatility
Breakeven: 1407.5
Bloomberg symbol: SPZ7 commodity OHT12
Comments: No reason to belabor this idea. If the credit market risk spreads to
the general economy, the Equity markets have tremendous downside. Volatility
is still relatively low and your terminal breakeven is reasonably high.
6
8) Buy puts on the USD vs. JPY currencies
March 2008 Japanese Yen futures at 86.73 (115.30 per USD)
Mid market on the March 07/08 expiry 87.00 (114.94) call is 2.10
That is an 8.65% Implied Volatility
Breakeven: 89.10 or 112.23 per USD
Comments: Similar in concept to above, a general contagion to overall
domestic economy will hurt the dollar, and the cheapest currency with the lowest
Implied Volatility is the Japanese Yen. We also like buying puts on the USD
versus the other major G-7 currencies.
7
Conclusions:
Despite our FED views, we do not want to downplay the potential for greater
problems to occur in the financial markets. As such, we do NOT advocate a “ride
it out” strategy. However, in the early stages of a market sea change, all
products tend to rise or fall in unison and only later is the wheat separated from
the chafe. The purpose of this RateLab is to identify those risk vectors that will
highly correlate to the key drivers of the market’s instability.
As noted, most of our suggestions involve buying Implied Volatility. This may
seem a tad late, but the reality is that Implied Volatility in Rates, Equities and FX
are all only now reaching their long-term averages. If the financial situation
indeed deteriorates further, there is still huge upside for Implied and Realized
Volatility in all asset classes.
ML US Rates Strategy
August 7, 2007
RateLab is prepared by the U.S. Rates trading desk; RateLab is not a product of Merrill Lynch (“ML”) Research. RateLab is not prepared,
reviewed or approved by ML Research. Any views expressed are as of the date and time of transmission. ML undertakes no obligation to
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