The second phase of asset price bubbles… May 9, 2013 at 8:02 pm
…is often buying on margin. So we can worry a little when Pragmatic Capitalism shows us this, courtesy of Orcam:
Category / Markets
…is often buying on margin. So we can worry a little when Pragmatic Capitalism shows us this, courtesy of Orcam:
JP’s recent research report into investment banking has generated a lot of comment (see for instance here for a nice piece from Matt Levine); Citi came out with their version the day before.
Let’s take (some of) JP’s handy cut-out-and-keep classification, add them into the mix (as they don’t appear on their own chart), and use some of Citi’s insights:
The tier 1 banks have a clear franchise. They have profitable IB businesses, global reach, and, – while challenged by regulatory change, – they clearly will stick around in this space. If you want to own an IB, you have to buy one or more of them*.
The tier 2 agency banks similarly have a clear role in life. They make money from flow, don’t have as high a compensation cost, or as volatile earnings. They are investable from an IB perspective.
The tier 2 institutional banks are where the problems are. They don’t have a strategy that makes sense, and likely won’t make enough money to pay for the costs of competing directly with Tier 1. UBS and RBS have already announced that they are exiting this space, presumably keeping a limited agency franchise. Jefferies could certainly follow the agency model, too. For the rest, there is a stark challenge. It isn’t clear that being an asset class champion (e.g. the French banks in equity derivatives or CS in credit) is viable. There isn’t clearly room for all of these banks to move to the agency box: in particular France doesn’t need all of BNP, Soc Gen and CASA in this space. MS, too, doesn’t have a strategic option that looks very attractive, and no tier 1 player needs what it does have enough to buy it. The political support for IB in Switzerland has waned, so CS might have a hard job pretending to be American in IB but Swiss in private client, especially with a niche IB model.
The play of the day is therefore long Barc, BofA, Citi, JPM, GS; short CS, BNP, Soc Gen, MS, RBC‡. This isn’t JP’s argument: they suggest that the tier 1 players can’t afford to exit a business with regulatory uncertainty and volatile ROEs, while the tier 2 players can. I agree with that, but critically that argument depends on the tier 2 players actually seizing the moment rather than wasting two years pretending to be top tier IBs when they are not, and wasting a lot of money in the process. I don’t believe that all of the players in red will have the guts to cut aggressively, hence the call.
*DB is perhaps the exception due to their need for capital to support the US businesss. Note while we are here that 4 out of 6 of these tier 1 firms are American.
‡Any banking trade that doesn’t have a UCG short in it does feel a little incomplete, though.
The overnight repo rate on the 2% T bond of February 2023 bond did some odd things in March, as Real Clear Markets reports:
[The repo rate] had been about 20 basis points in the week prior, but fell negative on Monday, March 11. By the close on Wednesday, March 13, the overnight repo rate was -2.95%. That day the Treasury sold $21 billion in a 10-year reopened auction that seems to have abated the negative repo after settlement… Such a negative repo rate indicated a sharp and acute shortage of collateral.
RCM suggests that the withdrawal of deposit insurance above $250K and QE caused a collateral squeeze. I don’t have a clear opinion on that, but I do know that negative repo rates that size are a cause for concern.
Scott Skyrm helpfully reminds us of an historic failure, that of Drysdale. The origin of the failure was a glaring arbitrage between the US repo market in the 80s and the treasury market. The former did not account for accured interest on repo’d t-bills, while the latter did. Drysdale’s head trader
started short-selling U.S. Treasurys outright, where he received the price plus the accrued interest. Then he borrowed the securities to cover his shorts in the Repo market, paying only the market price. He was getting the full use of the accrued interest on the bonds at no cost. In order to maximize to amount of cash he was collecting, he concentrated on shorting Treasurys about half way between the semi-annual coupon payment dates. With years of declining bond markets, he had made a lot of money shorting the Treasury market and by February 1982 his trades reached $4.5 billion in short positions and $2.5 billion in long positions… Overall, it was not a bad trading strategy since he won under two out of three possible market scenarios. If the bond market went down, he made a lot of money. If the market stayed the same, he earned free interest on the cash the trade generated. [But] If the Treasury market rallied, he risked a significant amount of money.
The problem, then, was that he was exposed to rising prices which would kill his short. Needless to say, that happened in spring 1982, and Drysdale collapsed. What happened next is insightful.
Drysdale had conducted their Repo trading mostly through Chase’s Securities Lending Department and Drysdale’s counterparties believed they were facing Chase and not Drysdale. Chase believed they were acting “as agent” for Drysdale, so they would not accept responsibility for the $160 million in coupon interest payments on that Monday, but the problem grew even worse. Up until then, the government securities market had operated under the assumption that the buyer in a Repo trade was entitled to liquidate the trade in the event of a default by the seller. There was no law on books differentiating a Repo from a collateralized loan and there had never been a case in court to set a precedent. The market was unsure whether they could liquidate the Drysdale/Chase Repo trades.
The lack of clarity as to the bankruptcy status of a Repo left Chase with a major dilemma. If the bank refused to pay the coupon interest to the Street and that contributed to any of those securities dealers going bankrupt, a future court ruling against Chase could expose them to liability for the damage they caused. However, if Chase made the coupon interest payments for Drysdale, they were clearly taking a loss and would line up as a creditor of Drysdale in the bankruptcy. It was a lose/lose situation.
On Wednesday, the Fed intervened and called together the heads of the 20 largest banks and securities dealers for a meeting at the Fed’s New York office. Not only was there pressure put on Chase from the dealer community, but also by the Fed itself. Though the Fed would later announce that their only involvement was hosting a meeting, quite similar to the future meetings for Long Term Capital Management in 1998 and Lehman Brothers in 2008. The next day Chase relented and, as they say, the rest is history.
The FED, then, prevented a market failure by leaning on Chase in the way central banks do. There were profound financial stability reasons for doing this, not least because of the uncertainty in the legal status of repo. Without knowing if a repo was a collateralised loan or a sale/buyback, no one knew what the exposure was. The law was subsequently clarified in favour of the latter interpretation (thanks to another bankruptcy Scott discussed, that of Lombard-Wall), but the lesson is clear: don’t engage in lots of transaction of uncertain legal status.
The stock loan business is, paradoxically getting less dirty because it is no longer washing. No longer washing dividends, that is, in tax arb trades. That is because ESMA has acted. The FT reports:
The profitability of lending programmes has been eroded by new guidelines from the European Securities and Markets Authority, which came into force in February, requiring asset managers to return all the revenues from stock lending, net of costs… New tax harmonisation rules in France, forcing domestic funds to pay the same rate of dividend tax as foreign funds holding French equities, are also expected to damp demand for stock lending during the spring “dividend season”. Dividend arbitrage strategies account for 80 per cent of European stock lending revenues, according to BNP Paribas Securities Services.
Step back for a moment. 80%? Surely that an activity is pretty close to being completely socially useless if four fifths of it is tax-driven? European stock loan is down two thirds from the 2008 peak. This is surely a very good thing. I have no problem with stock loan facilitating shorting, but clearly that useful part of the business wasn’t a big part of it.
Reuters, in between telling a interesting story of the impact of Kweku Adoboli’s losses on UBS, gives us some insightful information on the close out of his position:
The call that would eventually spell the end for [UBS boss Oswald] Gruebel came at 4 p.m. on Wednesday, September 14… [Gruebel] ordered a small taskforce — dubbed “Project Bronze” by those involved — to immediately close Adoboli’s open positions…
The Swiss stock exchange had to be informed by 7.30 a.m. With two-thirds of Adoboli’s open positions closed out overnight, the scale of the losses was clear and executives agreed they would have to say something…
Bankers said Adoboli’s positions were completely closed out by Friday lunchtime.
That would be a little less than two days, then, to get out of exchange traded positions (including ETFs).
Lehman Brothers Holdings Inc said on Wednesday it plans to distribute about $14.2 billion to creditors early next month… [this] will increase total distributions to about $47.2 billion, with two-thirds going to third parties.
The company has said it hopes to distribute more than $65 billion, on average about 21 cents on the dollar for allowed claims…
Following the distribution, holders of senior unsecured claims against the parent company will have received about 14.8 cents on the dollar on their claims
So, five years on, more or less, we are up to 15% recovery, with 20% in sight. Hmmm.
Jon, posting at the OTC space, does a nice job of setting out the size of various markets. In particular he uses gross market value rather than notional for OTCs, which is a (much) more useful measure. The results are interesting:
|Asset class||Market Size ($T)|
This makes one wonder about quite a lot of policy direction: to pick one example from many, shouldn’t there be a loan trade repository?
There has been a blog-fight between Bloomberg, whose editorial suggested that large US banks enjoy an 80 bps funding subsidy from the tax payer, and Matt Levine, who came to, well, a lower number. Now, I don’t really have a dog in this fight, but I was amused to note that SIFMA, a trade association, quoting the IMF, came to a 20bps subsidy.
Let’s assume that the subsidy is indeed 20 bps, and moreover that that 20 applies just to non-deposit funding. We will take JPMorgan, as that seems to be the paradigmatic example. JP has roughly speaking $2.4T of assets, funded by $1.2T of deposits, $200B of shareholder’s funds, and $1T of debt (quite a bit of it short term). So suppose JP enjoys a 20bps subsidy on that $1T*. That comes to $2B. Two billion dollars. To put this number in context, JPM’s last dividend payment was roughly $1.1B (30 cents a share last quarter to 3.8B shares). So the annual state subsidy JP gets, using trade association numbers, covers 40% of what JP gives shareholders. Um. I don’t know about you, but if this is even vaguely plausible, then the US taxpayer could legitimately be quite peeved about it‡.
*Obviously the 20 is a blended number; it won’t apply equally to all maturities of debt, nor equally to secured vs. unsecured funding.
‡For an earlier discussion of the UK taxpayer, see here.
The RBS 2011 annual review lists (roughly*) eight business lines:
Then there is the legacy portfolio.
It seems to me there are at least seven stand-alone businesses that you could create from this: RBS retail, corporate and investment banking including transaction services, a universal bank; Natwest UK retail; a wealth manager/high net worth bank based on Coutts; a US retail bank; Ulster bank; an insurer; and the legacy portfolio.
Surely the sum of the first six would be worth more than the current RBS? Mervyn has a point: such a split is more likely to unlock value than hanging onto 80% of RBS for another two or three years, especially given how things have gone in the last four years. A split would enhance competition in UK retail; and there is little logic to having the insurance and US retail businesses in the same group. Coutts probably does have lower costs as a result of leveraging off the infrastructure of the rest of the group, so perhaps you could leave that with NatWest – similarly you might want to keep Ulster bank in that group. But whether it is seven, six or five businesses, the case for splitting up RBS is hard to argue with.
Update. RBS has just announced the sale of 229m shares in Direct Line Group (DLG), with a further over-allotment option of 22.9m. This would reduce RBS’ stake from 65% to 48-50%.
*I’m ignore the Markets and International Banking reorganisation.
A timely reminder from Matt Levine:
nobody owns stock, they just own interests in their brokers’ interests in DTCC’s interest in stock. “Oh I own AAPL shares,” you say, but you don’t; you own like a second derivative on Apple shares. A delta-one derivative but still.
US GC repo is going lower, because, well, the Treasury has most of the assets, thanks to QE. Given that these assets are needed for collateralised funding and collateralised risk taking, that is having an impact. Izzy at Alphaville relays the following, very much along the line we have taken on this:
overly strict collateral policy, implemented post crisis, is now constraining the market’s ability to take on risk, because the ability to fund or run “risk-on” trades is determined by how many safe assets an institution has available for margin posting.
Risk positioning is increasingly being held back by a static pool of risk-free collateral.
Furthermore, if and when the risk positions sour, that divide only gets wider as further safe collateral calls are made, sucking more safe assets out of the system.
You can’t both demand that funding and risk taking are often collateralised then buy up most of the collateral without it having an impact.
These days, only a few guys (other than old guys) bet on the ponies, but just about everybody bets on the stock market. You take your money to the stock market, and you want to bet it on a winning stock. But you have a job, and an ever-loving spouse, and chores around the house, and kids to try to ride herd on, so you know that, truth be told, you have no time to learn anything about picking winning stocks. So up to you comes this guy called a broker, and a broker is nothing but a tout for stocks, only maybe not so honest…
Go read the rest: it has a nice metaphor of Corzine as a depression era tout.
An interesting observation from Steven Davidoff, who has been reviewing what was actually in the Abacus documentation:
Sophisticated investors are supposed to read the documents. We all know that retail investors don’t often take the time to read disclosure, but the securities laws are based on the idea that information is filtered into the markets through disclosure to sophisticated investors who then set the real price of the security.
This is a form of the efficient market hypothesis. If sophisticated investors can’t be bothered to read the documents and act on them, then we have a real gap in the entire disclosure regime and asset pricing generally.
I do think there is ample evidence that ‘sophisticated’ (at least in terms of the amount of money they have and the time they have been investing) did not read the docs of the deals they entered into. But that isn’t a flaw, that is a feature. Caveat emptor — they didn’t, and they lost money. That, surely, is the way it is meant to be.
The 14 big OTC dealers are becoming, well, at least 13 and likely 12. UBS is the certain loss, after its announcement of 10,000 job losses and a radical cut of its investment bank. In future UBS IB will focus on advisory, equities trading & FX. The upside, Citi research point out, is ‘potential c. CHF 11B (c. 23% of current market capitalization) of capital release’ – capital which is currently ‘generating sub-par returns’. Perhaps the good gentlemen of Basel, less than an hour on the train from UBS’s headquarters in Zurich, might care to contemplate the fruits of their radical increases in capital requirements for trading activities. Is greater concentration in FICC really a good thing for financial stability?
Update. Bloomberg reports:
The world’s biggest investment banks, which also include JPMorgan Chase and Citigroup, are facing less competition for business after UBS became the latest of Europe’s banks to shrink its operations, saying it will reduce fixed- income trading. RBS, which said in January it would close or sell equity and mergers advisory divisions, was also among victims as Europe’s debt crisis roiled markets and tighter capital rules made some businesses unprofitable.
The 10 biggest investment banks shared $22 billion of fixed income, currency and commodities sales and trading revenue in the second quarter, according to data compiled by Bloomberg Industries. JPMorgan ranked first, followed by Barclays, Citigroup and Deutsche Bank while UBS came in at second to last, the data show…
UBS may be realizing it can’t compete in products such as fixed income trading, which lenders such as JPMorgan and Deutsche Bank already dominate, said Christopher Wheeler, an analyst at Mediobanca SpA in London.
MS CEO James Gorman said in an interview with the FT:
“There’s way too much capacity and compensation is way too high”… “As a shareholder I’m sort of sympathetic to the shareholder view that the industry is still overpaid.”
Bloomberg describes the problem nicely in an article entitled No Joy on Wall Street as Biggest Banks Earn $63 Billion: it’s not that banks are not making money, it is that their ROEs suck. That means
We may be on the verge of a new kind of banking crisis, and that’s a banking crisis where no one wants to own any banks as an investor
As John Garvey from PWC told Bloomberg. Gorman meanwhile is asking himself if MS can get back to a 10 per cent ROE. You can see why no one wants to own bank stock…
*Of course, by tough I mean Porsche Boxster (ick) tough, not Volkswagen Up tough.
The European Parliamentary Committee on Economic and Monetary Affairs today voted 45-0 to place limits on high frequency trading. The vote is preliminary, but it is encouraging. As Bloomberg tells us:
Lawmakers backed a range of curbs on high-frequency trading in today’s vote, including a rule that orders must be kept in the market for at least half a second before they are canceled, and a requirement for traders to face higher fees if they withdraw excessive numbers of orders.
This would represent a massive increase in the safety and soundness of European markets if enacted. Well done Markus Ferber.
A nice analogy by Mark Cuban:
The best analogy for traders? They are hackers. Just as hackers search for and exploit operating system and application shortcomings, high frequency traders do the same thing. A [black hat] hacker wants to jump in front of your shopping cart and grab your credit card and then sell it. A high frequency trader wants to jump in front of your trade and then sell that stock to you. A hacker will tell you that they are serving a purpose by identifying the weak links in your system. A trader will tell you they deserve the pennies they are making on the trade or the rebate they are getting from the exchange because they provide liquidity to the market.
(He dispenses with the pesky ‘one is illegal, one isn’t objection straightaway’.)
Just one thought, given I am re-reading my response to the Basel Fundamental Review of the Trading Book ahead of a meeting later in the week: perhaps there should be an element of capital requirements which is based on the number of quotes sent. After all, each quote represents a potential risk, and you have no idea – given that your HFT algo may have bugs – whether it will be hit or not. $1,000 per quote seems reasonable to me…
New bank regulations and capital requirements are “structural” changes to the industry that are more to blame for declining profits than the U.S. economic slump, Goldman Sachs analysts said [in a note] … More than half of the top 25 U.S. banks aren’t earning enough to cover their cost of capital, leading to stock prices that are “significantly lagging previous global recoveries,” according to the note.
That particularly analyst’s note reads true to me. This business is not going to recover until someone figures out how to deliver more than 12% ROE consistently from a large bank. That goal would have seemed modest in 2006, but few seem able to meet it today.
FT alphaville had this as their chart of the day:
Now, there is a lot going on here including deleveraging, corporate cash hoarding, bank use of collateral (reducing the assets available in bankruptcy to support senior debt holders), increasing mortgage quality, and changes in bank resolution & regulation. Still, it’s an interesting chart.
At a time when EU officials are doing their utmost to make banks slim their bloated balance sheets, analysts have done the unthinkable and imagined what life would be like if European banks merged into a megabank… The analysts created Megabank by combining the most recent quarterly accounts of 22 banks. The gargantuan beast would have a balance sheet of some €23.7 trillion with gross loans of €9.2 trillion at the end of June this year. It would account for about 50% of the European banking sector, and have made a pre-tax profit of €44bn for the first half of 2012. It’s core Tier 1 ratio would have been 10.8%.
What I find particularly interesting about this – other than the size of the numbers – is the ratio of loans to total assets. It’s less than 40%. Do we really want the biggest European banks to have less than half of their balance sheet, on average, devoted to lending money?
SWP asks the question with regard to options for the reform of the equity markets. I reply market power, with appropriate regulation to constrain it: ban the dark pools, impose a central order book (so that the notion of best execution is meaningful and liquidity is maximised), and then regulate exchanges as utilities whose mandate is to serve real end users not algo traders. But that’s just my take – read his post then, if you like, tell me what you think.
First, how many contracts use Libor?
Quite a lot then, especially swaps.
Second, which Libors do all those swaps use?
3 and 6 month. OK.
Third, which Libors actually trade?
Ah. So 3m kinda trades and 6m doesn’t trade. Still, what could do wrong with a multi-trillion-dollar business linked to a fictional interest rate?
We didn’t need further evidence that the rise of high frequency trading has left the equity market vulnerable to destabilising behaviour. That has been obvious since the flash crash. But just to underline the point yesterday according to Streetinsider
Knight Capital Group is in some hot water Wednesday, following trading errors leading to larger-than-expected stock swings at the open.
Stocks of large-caps … saw moves from six percent to 10 percent or more higher … with no attributable news on the moves.
Following some trader outcry, a spokesperson for Knight Capital said it was looking into the problem. Later in the morning, headlines crossed that Knight Capital was telling clients to execute trades elsewhere
Knight Capital Group Inc. … was probing a software problem, according to people involved in the matter. U.S. exchanges said they were examining potentially erroneous trading in more than 100 securities that saw big price swings or unusually high volume.
In New York, Bane discussed reform of the equity markets and banning abusive orders, saying that it would be relatively simple to enhance market integrity:
Gotham, take control… take control of your city. Behold, the instrument of your liberation! Identify yourself to the world!
Reports that the SEC is seeking to hire Bane as director of trading and markets are unconfirmed. (OK, I might have made that last suggestion up, but seemingly the SEC doing something substantive about abusive HFT falls into the realm of fiction too.)
Update. This little episode could cost Knight $170M, according to Bloomberg. The stock is off 33%.
Let’s say we implemented a financial-transactions tax, or moved to a stock market where there was a mini-auction for every stock once per second: I doubt that would cause measurable harm to investors (as opposed to traders)
An auction in volume rather than time space would make more sense (auction once orders of dollar value bigger than x are in), but yes, that would remove a lot of instability. FTT would be enormously helpful too; any grit in the machine would dramatically reduce the risk of destabilising runs.
Further update. Simon very helpfully gives this link in his comment, which looks at the microstructure of the Dark Knight blow-up.
Meanwhile the WSJ reports that Knight faces a $440 million loss on yesterday’s market turmoil. They apparently had $1.01B of capital before this loss, so perhaps unsurprisingly they are looking at various financing options.
Final update. Knight drops 40% of its capitalization and the resulting refinancing dilutes shareholders 73%. So Knight’s shareholders suffer. Good. Now what about the poor schmucks who got terrible executions during the Knight-induced market ructions?
Via Alea, I found an interesting article in Euromoney about a presentation by JPMorgan’s Michael Ridley. He was discussing the parlous state of secondary bond market liquidity in Europe is one of the most worrying by-products of the region’s bank-funding crisis. Primary volumes in the first quarter were excellent, but secondary volumes remain low. Apparently bonds are often cheaper in the primary market than in the secondary market, and the challenging market liquidity situation is not improving.
The volume figures quoted in the article are rather scary:
Explaining that the US bank traded 5,000 names last year, Ridley noted that of the top 1,000 bonds, just eight traded more than three times a day. Twenty-six traded twice a day, 134 once a day and 832 traded just three times a week. Ridley added that 145,000 bonds on the bank’s books did not trade at all in 2011.
If you buy a corporate bond in the primary market, you should plan on a worst case holding period of ‘until maturity’.
A man wearing fourteenth century armour walking across a muddy field won’t travel particularly quickly. Put him in a crowd with longbows firing at him, and he is likely to have a very bad day. The Hundred Years war, from Crécy to Agincourt, showed that that expensive creation the armoured knight was no longer the cutting edge of warfare. The longbow was the crucial piece of technology that rendered him obsolete.
This all comes to mind reading a great piece of Citibank research on the profitability of the big investment banks. Basel 2.5 was the beginning of the end – FICC’s Crécy – and Basel 3 was the definitive engagement – FICC’s Agincourt. As Citi says:
- Assuming a full capital allocation on Basel 3, we estimate fixed income trading ROEs in 2011 were in the mid-single digits
- …Which would correspond to 13-14% ROE in a “normal” macro environment and no impact from regulatory headwinds…
- …But falls to 10-12% when we factor in our estimated impact to revenue pool from regulatory reform, although there will be a wide disparity.
In my view, FICC with an ROE close to the banks' cost of capital makes little sense. (Citi disagrees, quoting synergies with other higher return businesses such as investment banking.) Much of this activity is already moving to hedge funds, and this trend will continue unless ROEs improve - which they won't, thanks to Basel 3. It will take a long time for the edifice of large bank-based trading operations to be deconstructed, just as it took over a hundred years for the mounted knight to be replaced by lighter, faster moving troops. There will be be a few survivors: Citi suggests JPM, DB and BARC will be among them, and I don't disagree. The trend is clear though: in the long term, large and profitable FICC operations will become about as rare as the cuirass in global banks.
In the immediate aftermath, two things occur to me. First, this fits alarmingly into the pattern of doing enough to prevent an immediate crisis, but not enough to address the underlying problems, guaranteeing that another crisis will arrive in a few months. Second, I bet the Irish are exceedingly peeved by this. After all, they didn’t get a break anything like this, and have suffered huge pain as a result. Moreover the Spanish bailout doesn’t even give them hope that they can line up at the queue for that sweet sweet Euro-liquidity.
(HT FT Alphaville for the data.)
From the usually excellent TED, a nicely phrased three sentence argument for introducing compulsory ethics training for investment bankers:
…giving access to IPOs at 10 to 15% discounts to fair value is valuable currency for us to share with investors who trade with us, direct business to us, and generally bolster our bottom lines. We are in business, after all, and we have every right to treat some customers better than others if it promotes our own welfare. This is not moral corruption, it is business.
Um, no. It is how business has been done in investment banks for many years (as John Hempton says), but it is also fundamentally corrupt. The fact that TED can’t see this isn’t particularly a comment on him; it rather reflects a business that is in need of massive cultural change. ‘Best execution’ and ‘fair access’ aren’t nice pieces of marketing that should be more honoured in the breech than in the observation: they are the foundation of a fair market. Giving non-public price sensitive information to your friends and contacts or letting them buy in to a hot IPO – whether in precise detail legal or not – is simply unethical. If investment bankers fail to realise how odious this conduct looks to society and as a result don’t reform themselves (which seems to me likely), then society will in due course do the reforming for them. When that happens many of today’s sharks will be on the rubbish heap if they are lucky, and in jail if they are not.
From Soc Gen, via FT alphaville:
Implied volatility looks low overall, especially against credit spreads. The options market is split. Some assets trade at a significant premium against realised volatility, with safe havens like gold, JPY and USD rates left out with a low implied volatility.
Interesting. If you think the Eurozone is about to implode, buying that cheap vol could be a really good call.
I’m late with this, but I should be honest, so here goes.
1. Eurozone fears are overdone. Many market participants are in my view overestimating the likelihood of Eurozone breakup, especially in the short to medium term. Long the Spain/Germany spread.
Result. It made money on an accrual basis, but the P/L volatility on a mark to market basis was ugly. Score 1/2.
2. The developed equity markets are overbought. They are likely to continue that way for some time, so I like selling 3 or 4 year slightly out of the money calls on the Eurostoxx and SPX.
Result. The Eurostoxx trade, the SPX one (so far) didn’t. Score 1/2.
3. Japan might finally get its act together. OK, perhaps not that likely, but a medium sized punt on the Nikkei feels like reasonable value. Expect yen appreciation, though, so you might want to currency-protect that.
Result. Underwater, but not by too much. Score 1/2 mainly for calling the currency right.
4. Liquidity becomes better priced. Basel will force banks to consider security liquidity more carefully, and thus liquidity premiums will increase. Hang on to assets with great liquidity characterisistics for now, and look to bleed them out via two way total return swap structures or similar as the banks get more desperate.
Result. Hard to assess but certainly not wrong. Score 1.
5. Sovereign CDS basis to increase on the best quality countries. The trend in the previous point will make govies more attractive while CVA hedging will increase the demand for CDS. This will cause the CDS/bond basis to increase. Consider the negative basis trade on govies.
Result. That worked. Score 1.
3 1/2 out of 5. Not too bad. I’ll let you know where to leave the 2 and 20.