Equity vol and credit

[TheDevil]

So credit markets and equity vols are showing very different degrees of bearishness about the market. Without taking advantage of any arbs which you might be able to exploit (I havn't checked this as I can't trade credit) given the appropriate mandate what would you do?



a)Buy vol



b)Sell protection on a credit index.



c)Short the spread (presumably only credit and CB hedge funds can do that).



d)Take the view that the two markets have very little to do with each other, and trade RV in your favourite market (or do your thing, whatever it is really).



Personally I would do (a). But I am interested what other phorum members think.

[baghead]

a lot of people have been killed on that relative-value trade already.



The current situation is not driven by any fundamentals and is impossible to be captured by any vanilla models.

The credit market currently trades very technical. Corporate credit (which you are referring to) is driven by

a) being used as proxy hedge for "real risk assets" like large loan books or MBS

b) forced unwinds in super senior, AAA mezz and other structurd products

c) huge illiquidity (9 months ago every quote in IG/Main was good for at least a yard while now 100MM moves the market half a basispoint)

d) net convexity position of the street/correlation books



the combination of c and d makes it impossible to trade credit against any other asset class. For short term hedging, market makers in credit indices do use S&P futures as the intraday correlation is still quite high but that only works with a horizon of an hour or two until you are able to offload the position you caught.

Since CPDOs have switch their gamma's sign around the 90 (ITRX)/125(IG) level forced rebalanings of CPPIs/CPDOs and delta-re-hedging of short gamma correlation books are all-dominating shocks to the corporate credit level.



credit has mutated to a completely different animal due to technical factors and is impossible to trade in a capital structure arbitrage type of strategy against Equities at the moment.



It's interesting though that more and more vol guys look at credit.

I have seen interest in setting up marco hedging books on the Equity vol floor run by a credit guy to hedge tail risk and illiquid vols with single name products.

[kr]

What I'd underline here is that each market's behavior is ultimately governed by the character of its liquidity. I don't know much about what this means for equity but clearly the drivers of equity flows are much different than credit. So unless you can connect those in a clever way (lots of luck!), the different things will just go their own way. For instance, cash bonds are trading pretty far from CDS. As another example, I don't see bank reg cap impacting bank holdings of equity... probably that would just be internal merger arb which I'd guess has gone away already. The one place where there is some forced convergence is for names close to default, and unfortunately this has been driven by financial names where capital structure assumptions are really tricky.



If you want a homework problem, go dig out all the numbers on Northern Rock and see how things matched off. It would be educational.

[baghead]

surprisingly enough, the relationship was very strong on the day when the Countrywide takeover was announced.

CFC's CDS traded at 30%+500bps and recovery traded at 45%. To play the default would have had to put on 2.2x CDS against 1x Equity.



When it came out that BofA takes them over the CDS rallied in very hard (tightest print was 600 running) and then shot up and closed 7%+500.



So, while the CDS was 23 points tighter the stock closed up 50% resulting in an optimal ratio of roughly 2.2 : 1.

[TheDevil]

Thanks for your insightful replies Baghead and KR. I will look at Northern Rock CDS vs. vol, KR.



My thoughts are perhaps on a very superficial level but from my (very limited) understanding, CDS indices are currently implying that a significant portion of the economy will default (particularly in Financials). If even a tiny bit of this happens index vols will spike like there's no tomorrow. If this is only technical as you suggest, then I'm assuming that the cost of protection will fall to some resonable levels within 6-9 months as the stresses will sort themselves out (this might be where I'm wrong) and the carry would compensate for the short theta.



So as long as the position is not large enough to get the guy who puts this on fired when marked to market and given that the end of the year (PnL wise) is 10 months away there's time to wait for this to converge, this seems to me a decent strategy. Of course the main skill about RV spreads is to be able to call when to get in, so as this thing is driven by credit, will probably take place on a credit desk and not in vol trading.



What are the weak points in this argument?

[baghead]

you are absolutely right. current spread levels in indices imply an extrodinary number of defaults. ITRX 5y, for example, which is an index of 125 European INVESTMENT GRADE names implies 3.25 defaults (with 40% recovery) over the next 5 years..... every year....



If that happens we have people with guns on streets.



In the current situation buyers of risk demand a spread that does not only compensates them for defaults but for mtm pain the have to take on the way.



If you are in a situation that you have liquidity to invest and can take that pain you'll be laughing in 2 years time.



If anyone here has access to HNWI send them my way!!