How Mispriced Equity vs CDS Tail Risk Allowed A 158% Annualized Return In BP

Tyler Durden's picture

One look at the huge crowd at today's fantastic SocGen Tail Risk Hedging conference should confirm all fears that the bulk of speculative investors couldn't care less about riding the levered beta market, and instead everyone is focused precisely on the conference topic: how to isolate and hedge for tail risk (in addition to idiosyncratic, market, correlation and macro). While we will share quite a few of the thoughts by such prominent thinkers as Dylan Grice and Stephen Antczak, we wanted to highlight one trade which caught our attention: namely the mispricing of tail risk as represented by equity and credit derivatives in BP at the time when the company's bankruptcy seemed like a sure thing. Due to a major skew resulting from a huge imbalance in implied vol, a perfectly hedged trade which saw the selling of equity vol through near terms puts, coupled with the purchase of default protection via 6 month CDS, would have yielded a 158% annualized return at trade unwind 3 months later. In other words, which it is difficult to generalize, it appears that in times of dramatic risk, equity derivatives tend to overprice fat tail risk, while default protection is underpriced. Such capital structure arbitrage trades will become increasingly more profitable as the Fed-created drift between equity and credit accelerates, and as vol pricing allows phenomenal arbitrage opportunities.

In a nutshell, here is the BP case, which shows how a hedged pair trade, which was roughly $400k of margin on either side, ends up yielding a $324K profit, in three months, or just over $1.2MM annualized, on $823K initial margin. Of course, this trade could be leveraged infinitely. The return: a whopping 158%. This is precisely the trade that Bill Ackman put on during the 3rd quarter, as disclosed subsequently in his investor letter (although we are not sure if he actually sold puts against his BP CDS).

Full trade details below, courtesy of SocGen:

Many more observations from the most fascinating topic currently - Fat Tail Hedging - to come soon.