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.

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Cognitive Dissonance's picture

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.

Almost like the Fed is distorting the markets deliberately as another way to reward....ops sorry.....strengthen the under capitalized my bad......bankrupt organized crime families disguised as FDIC insured banking institutions.

Azannoth's picture

All the gold/silver junior are at or below the prices they where when gold was at 1250, so all the 'liquidity' has to be comming from short gold/silver stock positions, I have not made a cent in gold/silver stock despite a 150 dolar rise from when I bought wtf ?!?!

London Dude Trader's picture

Great cap structure arbitrage trade indeed.

Re. Pershing, it looks like Ackman made a plain directional bet by shorting BP credit through BP CDSs. 

Mercury's picture

Should any provisions be made here for the fact that equity options are guaranteed by the OCC and a CDS is contract is only as good as the couterparty's ability to make good on it?

Remember AIG?

Cognitive Dissonance's picture

But...but..but the government is guaranteeing everything, right? Right? RIGHT?

Mercury's picture

I'm just asking and I'm not sure about what shiny new features the CDS market has post-AIG but if CDS protection on BP were backed up by an authority with a track record like the OCC wouldn't it be that much more expensive?  Ackman more or less walks on water as far as I'm concerned but the CDS leg of his trade could have involved signifigant couter-party risk compared to his equity option leg (if there was one).  Although if he knew of and vetted the actual counterparty in the transaction but still bought the CDS at the going, "market rate" then maybe it was a risk well worth taking.

Cognitive Dissonance's picture

I should have used a smiley face above. :>)

I work on the premise that when the crowd won't play out the same way it did in 2008-09. Back then the US Gvt had some credibility remaining. This has now been surgically removed by the Fed over the past two years.

So I trust nothing, no counter parties, no government, no central bank, no exit signs or "this way out" doors, not even my sister who's still plugged into the Matrix as a lawyer, trying to make her last killing before she's unplugged.

Ha ha, just kidding about the exit signs. 

pyite's picture

If you are connected enough that Helicopter Ben has you on his speed dial - yes.


goldmiddelfinger's picture

I don't see the CDS unwind.

omi's picture

it's not arbitrage, more of a migration of risk along the capital structure.

wjs90's picture

Maybe I don't remember correctly but I looked at this trade back then but using 5y CDS (realize 6mos matches tenors but 6m liquidity sucks) and depending on what crappy merton type model you use the vols and implied def probs were fairly ballpark.

This trade to me seems more like a bullish bet with downside hedging (or long risk and heding your neg tail) than a vol convergance type trade.  Worst case goes bk<6mos and breakeven PnL around 50 recovery so really only earn on upside.

berlinjames02's picture

I'm no expert on CDS contracts, but doesn't it also matter what the bond is, and the 'loss' caused by the event?

For example, what if the bond is senior, secured debt? If the bond defaulted, the CDS owner would only receive money for the loss he suffered. (That loss might not be that much; ex. a $10M contract loses 10%, or $1M.) However, the person would be on the hook for a $4.23M equity position (max pain = sum of equity puts).

That would be a ~$3.23M loss.

I've made similar trades in options and have gotten killed on such bets. Please correct me if I'm wrong or I am missing something?

I love the thought experiment and the trade that was presented. Thanks for the post Tyler. Hopefully I can learn something and make some 'MAD Money' like Jim Cramer. LOL!

Zeilschip's picture

In general, around 40% recovery is assumed, i.e. in case of default you'd make 6mm on the CDS. However, the example doesn't seem right, the negative carry alone for running three months of the CDS contract is $90k, that's not even taking into account the loss you'd make on the mark-to-market.

jm's picture

Selling vol carries big downside risk, and the CDS leg has limited upside.

But this works great whenever vol is elevated, which it was for BP, right?

pyite's picture

This assumes that the loser on the CDS will actually pay up... is it possible to get default insurance against a CDS?  :P


DagnyTaggart's picture

How is this trade "Perfectly Hedged".  This trade is a disaster.  If the stock traded down hard, under 10 dollars say and did not default in six months you would get absolutely smoked.  In this environment this is a real possibility given bailout nation being applied to everyone and everything. 

Mercury's picture

Right, because an equity share price rout isn't the same thing as a debt default.

Back in the mid-2000's when convertible stock funds were the shit (buy the convert, collect the interest and short the common as a hedge, invest the proceeds) and touted as can't-lose money printing machines, GM's debt was suddenly downgraded, killing the price of the converts, then, Kirk Kerkorian, like 86 at the time and trying to impress his new girlfriend, announced a hostile bid for GM and sent the stock flying, squeezing the shorts.

Double ouch and so much for the perfect, apples/oranges hedge.

Godisanhftbot's picture

 C'mon, this was the trade of a lifetime , expertly described as usual with every possible permutation lovingly itemized. 


 You're just jealous you didn't take it.


 And frankly, I don't think  you measure gain against margin unless you are trying to impress the ignorant.