from Follow the Money

Lower vol = more imprudent bets?

November 6, 2006

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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That, in effect, is what some at the Bank of England think.  Mark Gilbert channels John Gieve.

``After a short pause in May and June, we have seen the return of aggressive risk-taking in financial markets this autumn,'' Bank of England Deputy Governor John Gieve said in an Oct. 17 speech to hedge fund managers in London. ``There must be a danger that risk models are giving too much weight to the low volatility of recent times.'' 

That sounds almost Geithneresque.  

If a trade offers less carry (because spreads have fallen), one way to keep returns high is to use leverage to scale the trade up.  Low volatilities can make larger positions consistent with the same estimated level of "value at risk" in most common risk management programs.   As long as volatilities are not just low but stay low, the bet works.   

Of course, the risk is that too many folks are betting that the recent fall in various kinds of market volatility proves to be permanent, not a blip.

I certainly am not in a position for sure to know if that is what folks in the market are doing.   But it often seems that way – at least in the areas I know reasonably well. 

 Yen-funded carry trades seem quite popular, even if the yen rallied a bit against the dollar late last week, the dollar had more volatile than usual week last week, and some short-term short yen positions were scaled back. 

Dr. Jen thinks central banks’ aversion to the yen (which may be changing) and Japanese investors – not hedge funds – are the real forces that have driven the yen down this year. I am not so sure.  I don't think the small yen share of cross border loans is all that great an indicator of the size of yen-funded carry trades.   There certainly is still talk of lots of folks using the yen to finance various trades.   And a number of other popular trades suggest strong demand for certain kinds of risk – and a willingness to reach for a bit of yield. 

Some one is dumping money into high carry emerging markets like Brazil (the real is strong, and would be stronger still but for intervention by Brazil’s central bank, which added $5b to its reserves in October).   Spreads on emerging market dollar debt are very, very low.  186bp on the EMBI.

Other credit spreads are also low -- very low.   Indeed, some banks apparently were caught betting that credit spreads would rise and are trying to hedge their exposure to better-than-expected conditions in the credit market right now, and in the process, putting downward pressure on spreads.  Gillian Tett and Paul Davies:

Those who have been buying protection in CDS markets - or expressing a negative view on the outlook for corporate bonds - have been wrong-footed by a combination of factors affecting derivatives prices. Company results have been strong, US interest rate expectations have shifted and there has been a wave of CDS trading linked to a new derivatives product called constant proportion debt obligations, recently created by some investment banks.

The unexpected price swings are believed to have caused pain at some big investment banks and hedge funds, some of which are reportedly now being forced to sell to cover their loses, exacerbating the market swing. "[Recent trends] have led to panic selling of CDSs," said Suki Mann, analyst at SG CI

That is rather the opposite of the risk I generally worry about -- namely that folks who are betting with leveraged money that spreads will fall will get caught on the wrong side of a trade, and their scramble to hedge will push spreads up.   That would mean panic selling of the bonds -- and panic buying of CDS. 

The folks who got caught recently were folks betting on rising spreads -- hence panic selling of CDSs (analogous of panic buying of the underlying bonds by someone who is short the bond when the bond's price is going up).  Go figure.

Alas, a lot of things are going on in the CDS market that I don't pretend to understand -- I had never heard of CPDOs (Constant Proportion Debt Obligations) until I read in the FT that they were impacting the market.    I am hoping that Gillian Tett will have a longer article soon explaining these moves for folks like me.    

All my musings here should be taken with a grain of salt.  I am working off inferences, not data -- and I don't claim to understand these markets perfectly.  But I am curious -- and hope to write more on the global carry trade later ... 

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