Oct

17

My idea is directed at fixed income types but should apply to other asset classes as well. Here goes:

Death of Salesman, RV Salesman that is: Most Relative Value (RV) ideas peddled on the street are not really RV trades at all. They are just another form of directional bets on whether the market will go up or down. And we all know that is pretty much random, at least in the short term. Can we measure how much “directionality” is contained in RV ideas? Sure. Simply look at the implied forwards against the current spot levels. If the spot vs. forward differential is anything larger than a normal bid-offer spread, then your RV trade is directional. Let’s look at an example. One of my favorite trades is the 5y- 30y swap spread in Japan. The spot spread was +135 on October 3rd and the 3m forwards implied a spread of 10 bp lower, or +125 bp. Ten year JGB futures, JBZ6 on your Bloomberg, was also a point higher at 134.61. Let’s further say you wanted to put $100,000 of risk to work on the 3rd of October. You either did 5y 30y spread for pv01 of $100,000 or you sold 119 lots of JBZ6. Today, the curve is 10 bp flatter and JGBs are down one point. So the PNL on both trades is about the same. But the return on the JBZ6 is much better since we used a lot less capital (leverage capital, and credit capital) to execute the trade. Further, the futures trade returns cash each day when there is positive MTM. So if you have positive expectations on your trades, and you should, futures are much better. You get to use the cash as it’s realized each day. How about a quick a dirty way to decide if an RV idea is better expressed by a simple directional trade? Simply divide the spot/forward differential by the RV Zscore. I call it the DZ score. A ratio of 1:1 is awesome but is tough to find. As the ratio moves further away from +1 it s gets harder and harder to justify an RV trade. The next time Mr. RV Salesperson knocks on your door, ask them how the DZ ratio looks. If it’s far from one, you’re better off kicking some futures around. This all comes down to the very obvious point that the amount of risk capital is potentially infinite whilst the amount of available alpha (sorry for the buzz word) is limited. It pays to be selective. Wait for the juicy pitch.

Ckin responds:

Some relative value terms that I often hear:

1. I can’t even create new bonds at this level!

2. This is the cheapest bond in my inventory on an option-adjusted spread versus libor.

3. That swap I proposed gives up 5bp in yield, but picks up 7bp compared to swaps.

4. This swap gives up 5bp, but you take out 4 points in cash and shorten option-adjusted duration by 2 1/2 months.


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