How's a levered hedge fund effectively selling a gigantic put option on its ability to finance its own positions?

Economics Asked on December 22, 2020

I grasp the basics of a put option. John C. Hull. Options, Futures, and Other Derivatives (2017 10 edn). pp 8-9.

A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

Can someone please ELI5 the bolded quote below?

“The Basis Monster that Ate Wall Street” (PDF). DE Shaw & Co. March 2009. p 3 of 9.

Of course, the value and even the sign of the cash-synthetic
basis vary over time. If obliged to guess prior to the present
financial crisis, most market participants probably would have
ventured that a basis position that was long the cash
instrument actually would have outperformed (that is, the
basis would have become more positive) in a crisis, as
worried investors would be expected to buy protection in the
form of CDS, thereby pushing credit spreads on CDS wider
than those on the underlying cash bonds. A research report
issued by Lehman Brothers in August 2005, for example,
noted that “hedging demand amid increased market
volatility kept CDS spreads wider relative to cash.”‘ But
events have unfolded very differently in this crisis While the
long cash/short synthetic bases of a few issuers may have
outperformed, that’s not been the case for the majority of
issuers during this now protracted financial crisis, and a
decision to put on long cash/short derivative trades as a rough
form of crisis insurance would not have worked out very well.

What’s critical here is that the two risk factors most
responsible for driving cash-synthetic basis—namely, the
availability of financing and the positioning (long or short
cash relative to synthetic) of levered players—are quite

p 4 of 9.

inconveniently also two of the least desirable risk factors for a
levered investment vehicle like most hedge funds. Those
factors’ combined impact literally describes the terms of a
classic common-investor liquidation crisis. By incurring heavy
exposure to financing risk and the portfolios of other levered
investors, a levered hedge fund is effectively selling a gigantic
put option on its ability to finance its own positions.

Moreover, this put option has characteristics that greatly
increase the probability that the option will move in the
money at the worst possible moment. If a levered investor
suddenly finds itself facing heavy losses, it’s not a stretch to
suppose that, at the same time and for largely the same
reasons, that investor’s equity capital base is under pressure
from redemptions, its financing position is weakening
because of a credit crunch, and other similarly positioned
investors are liquidating. Worse still, all of these phenomena
tend to self-reinforce in pernicious ways. In such
circumstances, it’s imprudent to count on financing and
trading counterparties to provide help because, as already
noted, they’re likely to be deleveraging at the same time.

One Answer

This was a really good question, and a fascinating topic (one that was admittedly hard to wrap my head around). I found a great video on this topic here.

When people say you're selling a (cheap) put option, they generally imply you're taking a needlessly big risk for only marginal upside. For example: not having adequate cash in your portfolio is essentially selling a cheap put on your liquidity. You get the marginal gain of avoiding cash drag...but you get absolutely steam-rolled if you're hit by a margin call. Best case you enjoy extra 1% / year, worst case you get annihilated. Seems asymmetric, no? I think that's what they're implying.

So, in an ideal world, you take JUST the position of cash-synthetic basis mispricing. BUT, DE's point is you're taking that risk PLUS the risk of whether or not other leveraged hedge funds can finance their position. Ominously enough, you're likely part of that "leveraged hedge fund" group yourself. If a competitor loses their financing, they will have to liquidate their trade. If they liquidate, it makes the mispricing WORSE. As they liquidate (and your trade moves against you), you likely ALSO have to liquidate because your financing is also drying up. All of these things would happen at once, and would self-reinforce.

Put succinctly, you are taking two co-amplifying risks (financing options + basis mispricing) - but only really getting paid for one of them (basis mispricing).

Does that hopefully help?

Cash-Synthetic Mispricing

This is essentially when you can buy a bond yielding 3% / year, and then turn around & buy insurance on it for 2% / year. It is riskless arbitrage...and theoretically Capitalism should compete it away. The difference between my numbers above (the 2% and 3%) is the "Cash-Synthetic Basis" referenced in the DE Shaw article.

"Cash" is a misnomer that refers to the actual underlying bond. "Synthetic" means a CDS, or some sort of synthetic instrument.

Correct answer by Davis Clute on December 22, 2020

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