- Call spread A = long call option with a strike of $0, short a call with a strike of $3.
- Call spread B = long call option with a strike of $3, short a call with a strike of $7.
- Call spread C = long at $7, short at $10.
- Call spread D = long at $10, short at $15.
- Call spread E = long at $15, short at $30.
- Call spread F = long at $30, short at $100 (I know we've limited the stock to $100, but work with me here).
Let's say the index trades at around $1.50. Call spread A is most sensitive to changes in the index price (relative to the other call spreads) since it is "at-the-money" (ATM). In contrast, the $30-$100 spread offers little value since it is so far "out-of-the-money" (OTM). If the stock price increases to $5, call spread A has moved completely "in-the-money" (ITM) and is no longer as sensitive to moves in the underlying index (the maximum PnL for the spread has been realized). Call spread B is now the ATM option portfolio. As the index price moves, the value of each call spread will fluctuate depending on whether it is ITM, ATM, or OTM. Another way to look at it is in terms of option premium. If the index is trading at $1.50, I'll likely get much more premium by selling call spread A or B than call spread F.Now let's consider the constituents of this index. Let's say it's made up of biotech companies that are highly dependent upon a certain upstream compound, pending FDA approval, for their businesses to succeed. If the compound is approved, these companies are going to make tons of money and the value of the index will likely approach $100. If it is not approved, the value of the index will approach $0. Your estimate of the compound's likelihood of approval will bias your estimate of call spread relative value. If you think approval is more likely than expected, you may be able to purchase the $30-100 call spread cheaply since it's OTM. If enough people agree with you, the premium associated with the $30-100 call spread will be driven higher until it reaches some equilibrium level. This reflects the binary nature of the approval process and the highly correlated expected returns of the index constituents. The example would be much different if the index was made up of a well-diversified group of companies, spanning different sectors, etc. Some constituent stocks will go up and some will go down, but one might expect the distribution of potential index values to approach something more bell-curved than the binary outcome described in the biotech example. In this case, the value of the $30-100 call spread will remain low since the index probably won't generate those higher expected returns (again, relative to the biotech example). Now stop. Replace the "$" signs in the example above with "%", generalize the "biotech vs. diversified" discussion in your head to correlated vs. uncorrelated, and substitute "expected loss" for "expected return." You officially understand standardized synthetic tranches. Tranches on the standard CDX index work in exactly the same manner. The expected loss of the index is tranched into 0-3%, 3-7%, etc., slices. If the index is implying a loss of 1.5%, for example, the 0-3% tranche is the ATM tranche. The intuition regarding the greeks, discussed in previous posts, follows naturally (delta, gamma, rolldown/theta, vega/correl01). One common stumbling block is the whole expected return vs. expected loss business. To be explicit, credit guys are primarily concerned with expected loss (default risk) whereas equity guys are focused on expected return. If I buy protection on the 0-3% tranche, I expect default risk to increase. When I buy the $0-3 call spread, I expect the stock price to increase. So remember, when you talk about CDS, you should talk explicitly in terms of buying and selling protection.
- Buy protection = I expect things to get crappier (I want to short the credit)
- Buy call option = I expect things to improve (I want to get long the stock)
So from a directional perspective (crappier <–> better), I suppose buying tranche protection is more like buying a put spread on a stock/index. For whatever reason, though, I prefer to think of it as buying a call spread on expected loss. This preference is driven by the quoting conventions of credit vs. stocks. CDS is quoted in spread (which reflects default risk) while stocks are quoted in terms of price.The same term structure considerations are also applicable, though one should remember CDS maturities (e.g. 5, 7, 10y) are much longer than equity options.
Anyway, there are direct lines one can draw between stock options and standard synthetic tranches. Hopefully this helps bridge the gap. And for something totally unrelated, here's a link to an oldie but goodie:
I just noticed I passed 100 posts a little while ago. Small potatoes in comparison to the geometrically increasing data puking contest that is the Internet. Nevertheless, as we close out 2009, I thought it would be interesting to review the top five posts:1) Delta and Mark-to-Market. A brief explanation of corporate synthetic tranche value sensitivity to the underlying portfolio.
2) Use your.flowingdata.com…for the children. Track your baby's sleep schedule (and pretty much anything else) via Twitter.
3) Sqlite and Sqlalchemy. An example of using python and a popular object-relational mapper.
4) Using Google Apps Python Provisioning API. An example of pulling user data via the python API and writing it to excel.
5) Use python and sqlite3 to build a database. A quick intro to python's sqlite3 module. The "best of the rest":
- quotes_historical_yahoo from matplotlib.finance. A brief description of pulling yahoo finance data using matplotlib.
- Parsing DTCC Part 1. My first (incomplete) attempt at scraping data from the web using curl, BeautifulSoup, and numpy.
- YACP. "Yet Another CDO Primer" video split into part one and part two.
- Fixed coupon CDS is the same as CDX. A brief explanation of how new "Big Bang" coupon conventions aren't really new.
It's been an interesting year. While most of my posts are derived from Interweb tidbits I find interesting, my original posts were much more popular (according to the admittedly crude Posterous stats). I have no ambitions for this blog, but I hope some of the factoids featured here have helped you or at least offered some entertainment. Best wishes for 2010!
I've gotten a few questions about gamma vs. delta as it relates to tranches (partially in reaction to an old post), so I thought I'd post my response here.As I mentioned in "Delta and Mark-to-Market," one way to describe tranche risk is in terms of delta:
The delta of a tranche describes the leverage of a tranche relative to the underlying portfolio. So if a given tranche has a delta of 3x, a one dollar swing in the underlying portfolio should result in a roughly $3 dollar swing in the value of the tranche.
So, in the correlation market, one can "delta-hedge" spread risk by buying/selling the underlying index against the tranche. Given the example above, if I sold $10m in tranche protection and wanted to delta-hedge, I would buy 3x notional (or $30m) index protection. Theoretically speaking, this hedged position is now immunized against spread movement but still exposed to correlation risk.As I also mentioned in that older post, however, tranches gain and lose delta depending on the expected loss of the underlying index. If the expected loss of the index is moving toward the attachment/detachment point of the tranche, the tranche gains delta. If expected loss is moving away from the attachment/detachment point, the tranche is losing delta. This change in delta is sometimes called gamma risk. A position that is "long gamma" typically benefits from market volatility. The easiest way to explain this is to examine a hedged position. Let's examine a delta-hedged equity tranche position, where one sells equity tranche protection and buys index protection. Back when spreads were low, the equity tranche exhibited deltas on the order of 15x. So for the sake of argument (meaning the numbers that follow are completely made up but are directionally accurate), you'd sell $1 million in equity protection and buy $15 million in index protection. Now, let's assume the index spread increases such that the equity tranche delta has fallen to 10x. As a result, your delta-hedged position is now over-hedged, in the sense that you own 15x delta but only need 10x. So you can now sell your excess $5 million in index protection at a profit (since you bought protection and spreads are higher). As a result, you've experienced a mark-to-market loss on your equity tranche, but made money on your hedge. Now let's assume spreads fall again, such that your delta increases to 18x. You now buy more index protection to reset your hedge. If this process repeats itself over time, with spreads oscillating back and forth, you'll make money on your hedge by "buying low and selling high" due to the change in delta. This is an example of a "long gamma" position that benefits from market volatility. There Keep in mind that the numbers in the example above are pretty crude and not representative of what you'd see in current markets. Nevertheless, the basic mechanics should provide some decent intuition.
This article describes a recent study by Tim Garrett, a scientist in Utah. The study is based on the concept that physics can be used to characterize the evolution of civilization. From the article:
"I'm not an economist, and I am approaching the economy as a physics problem," Garrett says. "I end up with a global economic growth model different than they have."
Garrett treats civilization like a "heat engine" that "consumes energy and does 'work' in the form of economic production, which then spurs it to consume more energy," he says.
"If society consumed no energy, civilization would be worthless," he adds. "It is only by consuming energy that civilization is able to maintain the activities that give it economic value. This means that if we ever start to run out of energy, then the value of civilization is going to fall and even collapse absent discovery of new energy sources."
Garrett says his study's key finding "is that accumulated economic production over the course of history has been tied to the rate of energy consumption at a global level through a constant factor."
One zinger comes towards the end:
"The problem is that, in order to stabilize emissions, not even reduce them, we have to switch to non-carbonized energy sources at a rate about 2.1 percent per year. That comes out to almost one new nuclear power plant per day."
I have no idea how solid this type of analysis is, but it sure is creative! It can't be any worse than some of the other models out there that are currently in use…