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Harley Bassman Returns With Extended Perspectives On Implied Vol, The Yield Curve, Convexity, Duration And Much More
Harley Bassman, who used to run ML's RateLabs is back on the scene, now as part of ML prop (hmmmm) and we are happy to present his two most recent "Convexity Maven" research pieces. Not for the faint of heart - serious curve expertise required. And for those brave enough, an idea for one of the cheapest catastrophe insurance trades: "What to do ? The only reasonable “bear” trade is some sort of mid-dated payer spread. Buying 2yr to 5yr expiries will reduce the time decay issue so you will have more time to wait. More importantly, by selling the OTM payer you reverse the large cost of “dynamic” risk. This will be a huge carry reducer since you would now be paying for the Curve and Volatility risk vectors but selling the Skew risk vector. Since Skew accounts for almost 20% of the cost of a 3yr-10yr 200bps payer spread, this is significant."
Wearing a Belt And Suspenders:
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http://stat-arb.net/pdf/implied_corrwp00-02.pdf
damn..... that hurt my head. That's pretty damn sophisticated bond trading stuff right there.... I understood it, but damn.
The only comment I'd make is that it seems to be overthinking it quite a bit... most traders I know of right now are using the 1970's concept of how Volker broke the back of inflation, which is actually a page from Wicksell's Interest and Prices, raising the interest rate to force devaluation of assets while allowing savers to earn large returns from capital investment in the country. This large influx of cash was done with a relatively low debt level and subsequently raised the debt.
The difference is that in the 1930's we still had a huge debt overhang from WWI that needed to be paid down but they needed to lower the rate. This was accomplished by the start of the Treasury Bill program in 1929 (december if I recall correctly) and market crashes lowered the rate of interest while allowing for an increase in the debt level without causing an increase in the interest expense. This is a page from the 1930's but all bond traders continue to look at the 1970s. Seriously, individuals as bright as this man do need to look a bit further back before overly complexifying the situation. That being said....
DAMN.
Be nice to see 30 yr swap-treasury spreads posted to gauge liquidity premium.