Value Concepts from the BAS/ML Trading Desk

August 27, 2009

Implied Volatility Heading South for the Winter

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Our previous RateLab – “Long Live the King (Bernanke)” August 26, 2009
detailed the implications of another four years of a Bernanke FED. In summary,
his well advertized plans for conducting Monetary Policy should reduce uncertainty
and Volatility in the market. This will most likely result in a reduction in the recent
record levels of Implied Volatility. This RateLab will detail our thought process and
recommend an idea.

The –blue line- below should be recognizable to all; it’s our famous MOVE Index.
To refresh your memory, the MOVE Index is the blended Implied Normalized
Volatility for one month options across the Treasury Curve. It is available on

All charts, unless otherwise noted, are sourced from BAC/MER data

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Bloomberg via the function: MOVE Index gp <go> The MOVE most recently
closed at 126 which roughly translates into a daily move of 8bps. Although this is
down considerably from the June average of 172, it is still well above its 21 year
average of 104 (6.5bps/day).

Presently, almost all options activity is being conducted via swaptions. Therefore,
swaptions are a much better measure of Implied Volatility and the cost of
Convexity risk. The –orange line- below is the Implied Volatility of the benchmark
6 month into 10yr swaption.

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Its recent close was 160 Nvol or 10bps a day. This is about 2.2 Standard
Deviations above its 15 year average of 108 Nvol. Since the Yield Curve has been
so volatile, many traders prefer to look at the cost of Convexity for other “tails”.
In the chart above, the –green line- is the 6 month into 2 year Implied Volatility
while the –red line- is the 3 month into 5 year Implied Volatility. The 6m-2y
closed at 134Nvol versus its 15 year average of 110Nvol while the 3m-5y closed at
165Nvol versus its long-term average of 114Nvol.

Short-dated “gamma” options often explode in price during a time of stress.

However, this time the entire Volatility surface rose. Below, the –purple line- is
the Implied Volatility for 2 year into 10 year swaptions, one of the MBS Vega
benchmarks. Also below is the -maroon line-, the 5 year into 5 year benchmark.

Although Implied Volatilities have declined from the mega highs set in June, they
are still 25% to 45% above their lifetime averages. However, this alone does not
support entering a risk taking trade. We need a bit more meat.

Implied Volatility is most strongly correlated with Actual (or Realized) Volatility.
Implied Vol (via time decay) is the rent paid for an option while Realized Vol is the
income generated by “delta” hedging; these two must converge over time in order
to eliminate arbitrage profits. Although one tends to lead the other at various
times, over many weeks, Implieds track Actuals quite well. In the chart below, we
compare the Implied Volatility of 3m – 10yr (–blue line-) and 6m – 10y (–green

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line-) versus the –red line- of Actual Volatility. Notice how the declining Actual Vol
is pulling Implied Volatility lower. Everyday that the Implied Volatility is above
Actual Volatility, the option longs are losing money, i.e., their theta losses are
greater than their hedging gains.

So the question is: Why should we expect Actual Volatility to decline even further ?

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Although the cycles can sometimes be quite long, many markets tend to exhibit a
“Regression Towards the Mean” (RTM). The RTM effect is why the Yield Curve
twists in response to FED action. It is also why the Volatility Surface is negatively
sloped from the mid-expiry point to the long-expiry point. Most critically, it is why
distant Forward rates tend to be much less volatile than Spot rates. Following this
logic, the chart above indicates that the Rates market may have finally found its
level and might settle down for awhile. The –green line- is the 1 year rate
reflected 5 years forward. Similarly, the –blue line- is the 5 year rate 5 years
forward while the –pink line- is the 2 year rated projected 10 years forward. Not
only have all these converged to about 4.90%, but also this level is within 30bps
of their five year average of 5.20%.

It is likely that the markets have listened carefully to Bernanke and are starting to
develop a consensus as to the long-term level of rates. This does not mean that
the market is right, it simply implies that markets will probably stabilize until new
information is introduced. Specifically, how and when will the stimulus be
removed. But as noted yesterday, that event is most likely a distant one.

Finally, we at the RateLab are particularly fond of looking at large liquid markets to
take our queues instead of volatile illiquid ones. The MBS market is the world’s
largest bond sector and this is where “real money” most clearly speaks. The –pink
line- below is the Libor OAS for the Par MBS bond. It is presently at -10bps.
However, if Volatility declines by the 20% we predicted in the last RateLab, all else
equal, our analytics will produce an OAS of +10bps. That is equal to the pre-
bubble average set during 2001 to 2003. In a nutshell, it seems as if the huge

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MBS market has already priced in the fair market valuation before the less liquid
swaptions market had a chance to vote.

Conclusion

Markets are traded by people, not machines; and a person’s ability to absorb risk
and anxiety is limited. This is why ultra volatile markets eventually calm down -
traders become exhausted and close out their risky positions. Although it certainly
felt as if the world was going to end, the reality was: This too will pass. It is now
seeming more and more likely that although Bernanke may not be able to
guarantee a good ending, at least he can make the path there less bumpy. As
such, both Actual and Realized Volatility should slowly decline. Six month 10yr
Implied Vol is too high; it can decline by 20% and still be a full Standard Deviation
above its lifetime average. We recommend selling 6m to 2yr expiries on 5yr to
10yr tails.

Trade Idea

Sell 200mm 6m-10y -75bp rcv k = 3.15%

Buy 100mm 6m-10y atm std k = 3.90%
Sell 200mm 6m-10y +75bp pyr k = 4.65%
Pay $1.875mm net selling 155Nvol

Harley S. Bassman
BAS/ML US Trading Desk Rates Strategy
August 27, 2009

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The above commentary has been created by the Rates Strategy Group of Banc of America Securities LLC (BAS) for informational purposes only and is not a product
of the BAS or Merrill Lynch, Pierce, Fenner & Smith (ML) Research Department. Any opinions expressed in this commentary are those of the author who is a member
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