Saturday, January 9, 2010

Derivatives Across the Capital Structure Time for Tail Risk Hedges

Time for Tail Risk Hedges

A prominent theme: One of the key themes coming outof this cycle is the secular demand for hedging, and we see a lot of interest in tail risk hedging strategies today. With spreads much tighter and option volatility much lower in both credit and equity, with believe the time is
right to consider these strategies. However, we expect a continuation of these themes and consequently encourage a tactical approach to hedging strategies to adjust for further opportunities.

What constitutes a tail scenario? We consider two scenarios that appear to fit investor concerns. Our small tail scenario assumes a 15% decline in equities, 30bp widening in IG spreads, and 150bp widening in HY spreads. Our large tail scenario assumes a more severe 60bp widening on IG, 350bp widening on HY and a 30% decline in stocks.

Small tail hedges: In equities, we prefer slightly OTM put spread strategies in the S&P 500, which can have a payoff of greater than 5x in this scenario. Additionally, we consider sector hedges in Technology and Industrials. In credit, we similarly like put spread strategies and prefer using a rolling shorter dated expiry as opposed to a longer horizon at trade inception
Large tail hedges: In equities, we prefer OTM puts, short 1x2 put spreads, and ATM puts that “knock-in” on lower moves in equities. On the credit side we like OTM puts and selling 1x2 put spreads as well, as these have attractive upside at minimal cost. We caution that in a moderate tail scenario, this strategy could underperform, so we highlight it as a large tail hedge only.
Credit index tranches: In addition to a variety of options strategies, we continue to like certain senior and super senior tranches as large tail hedges in credit, as cheap no-delta shorts on a broad index widening. [morgan stanley]

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