Fixed Income Liquid Markets Research October 2003 Macro-Awareness in Relative Value Trading Bruce Tuckman LEHMAN BROTHERSLehman Brothers | LMR Quarterly LMR Quartery, vol. 2003.02 Bruce Tuckman 212-528-2262 bluckman@lehman com Macro-Awareness in Relative Value Trading ' Relative value trading assumes a stable macroeconomic environment. While this rading style may work well within macroeconomic regimes, itis dangerous across regimes. Focusing on 2s-5s-10s for concreteness, this paper 1) shows the empirical connection benween the level of 2s-5s-10s and macroeconomic regimes; 2) uses term structure models to describe what goes wrong with relative value trades during a regime shift; 3) describes recent changes in te levels of 2s-58-10s in terms of changing ‘macroeconomic views; and 4) suggests ways in which to make relative value trading 4.__A RELATIVE VALUE DREAM TRADE TURNS INTO A NIGHTMARE While certainly an oversimplification, relative value trades are often analyzed and undertaken along the lines ofthe following case study. in mid-1999 there is talk tbat S-year swaps are trading cheap on the curve. To check ths aim, a trader might ain a regression of changes in the S-year swap sate on changes in the 2-year and 10-year swap rates over the sample pesiod June, 1997 to Tune, 1999, obiaming regression coefficients of $5 on the 2-year and 60 on the 10-year. The, these coeificients sy be used t peta time series ofthe "By." defined ae Fiy= yy 45* 3 ~.60* yy (1) ‘This plot, with constant added so as to contr the ly shout O, is shown in Figure 1. High ‘values of the ly indicate that Ss are cheap relative to 2s and 10s while low values indicate that Ss aresich Also, the change in the fly gives the captal gain or loss, per umst of DVO1, of | 1a position in Js hedged with 45% of sts DVOI in s and 602% ofits DVO in 10s. Fer example, ifthe By moves frm -7 1 Obp, the capital gin from selling Ss while busing 2s and 10s, ‘equals Tbp times the DVD] of 5 in the position. In any case, Figure 1 seems to supper the claim that Ss are cheap, While thir relative value oscillated sharply during the mmoil ofthe sumer and fll of 1995, the time series does seem to fhacunte around D. Should this ‘behavior continue, buying 3s while selling 2s and 10s as of mid-1999 could produce 5bp or smote of profit “Most elative value traders would not rely on the history of the fly alone. They world ask round the street to determine wh Ss were wading cheap. Has there been a lt of payin: interest n Seto hedge comporate issuance? Are one or to large players in the midst of @ ‘program to pay in 5s? In any case, only after understanding the reason for the seeming dislocation would most relative value traders actually put on the trad, ‘i paper wae ressrad tte 2005 Lows Mise Fowm Goo, an ene Soerara Ne eoaeh Gerber 300 Please see important analyst certification() at the end of this report. 7Lohman Brothers | Fized Income Research Lie Quarterly, vol. 2003-02 Figure 1. The ly indicates a relative value trade opportunity Basis Poets 10 5 4 2 o 2 4 6 a TOELULEAT PELE EGE Fiy=y(6)-0.45)(2)-060)(10)+¢ “i As ithappens. trading ftom June, 1999 to March, 2001, based om the seaession analysis ‘performed in June, 1999, would most kely have proved quste profitable. Figure 2 eppends ‘the behavior ofthe fly over tis wading period to Figure 1, chat i, ta the behavior ofthe By ‘over the estimation period. Because the fy continued to fnctuate around 0, there were several opportunities to trade 5s elative to 2s and 10s. For example, ale to buy 3s when the By in the araph rose above Sbp and to sell Se when the Ay fll below Sbp would have made money several times: long 5s in Tune, 1999; long Ss in early 2000; and short 5s in September, 2000. ‘In any case, in March, 200] the relative value wader faces neatly the same cheapness of 3e ‘thet prevaited im June, 1999. This time, however, the prospect of buying 5s might seem even _sore anractive given the succesefol track record ofthe trading role over the previows vears. Figure 2. The fly works well as a relative value ineator Baie Pons 10 nm BeoLWON bao PetEe eel 5) -0.455(2)-0604(10) + ‘Unfortunately for anyone reasoning this way, the behavior ofthe fy after March, 2001 did ‘not resemble its past behavior Figure 3 shows that a trader relying onthe previously secesfil rule snd buying 5s in Mare, 2001 would have lost about 1Sbp over a five-month period (Note the change in scale ftom Figure 2 to Figure 3!) Tis loss is quite large relative 1 the previous gains of about Sbp or lesson each ofthe few turns over the previous years. ‘October 2007Lehman Brothers |Fixed Income Research ‘Lua Quarterly, vel. 2003-92 Figure 3. The fly fails miserably as a relative value indicator ‘ass Fete 3 2 6 0 5 0 5 TULCt Peep eee eee Fly=y(6)-0.46)2) -060,(10)+¢ Marker participants tend to describe the breakdown ofa relative value relationship, like the fone inthis case study, a8 “a once-in-100-year flood” or a5 2 “10-standard deviation event” ‘Bur these phases are quite misleading. In early 2001 the Federal Reserve stared easing ‘monetary policy and the market had begun to worry about a prolonged econemic slowdown “As this paper will argue, it was not some random shock but rather the change in the ‘macroeconomic environment that eaused the relationships across 2s, 5s, and 10s to break down. A participant close to the mmol oF he fixed income markets in 1998 used the following analogy when responding te characterizations of the eveats ofthat time as 10-standard DVOL; +-8DVOLy =DVOL, @) In words, because 10s are fess volatile than 2s and Ss,» hedge position requires more DVOL in 2s and 10s than in Ss ‘The term structure of volatility is usually downward sloping because longer-term rates are less affected by economic news that shorer-term rates. Also the volatility of Ss tends to be loser to the volatility of 2 than the volatility of 105i othe volatility of Ss. Tesether with the discussion sn the previous paragraph, thee facts argue that butterfly hedges will usually shave more weight on the wings than in the center. [Renurming tothe second cofuran of Table 2, the ratio ofthe DVO1 of the wings to the DVOL of the center does indeed exceed 100%, Furthermore this ratio has increased from February 3, 2001, ta May 23,2003, The discussion abou the term structure of volatility cevealed thatthe reat the curvature of the volatility curve the greater the fraction of DVOI on the wings. A -macrozconornss interpretation ofthis starement is that the greater the mtermedkate-terma “uncertainty eelarive to che short- and long-tsem uncertainy, the greater the faction ofthe [DVOI on the wngs, The ratios in the second column of Table 2 indicate, therefore, that ‘elie intermedite-tem economic incerta hes increased over the past Two Years ‘The previous section used a change inthe perceived speed of economic recovery as an example ofa regime shift. A change in the curvature ofthe volatility curve, that is, inthe ‘lative uncertainty ofthe intermediate term outlook, is another example. In fact, according to ‘Table 2 the cegime shis stom February 5, 2001 to September 4, 2001 was due to an increase in the relative uncertainty ofthe sntermediate-term outiook, while the reeime shift May 23, 2003, was du in par to such a change but mostly tothe view of a slover esanomic recovery ‘In any cabe these nwo effects can be wed to explsin the regime shifis in Figure 4 ‘October 2003 7Lehman Brothers | Fixed Income Research aa Quarterly, vol. 2003-02 MAKING RELATIVE VALUE TRADING STRATEGIES MORE MACRO-AWARE. ‘This paper araves that relative value trades and even the hedge ratios ofthese trades make ‘implicit macroeconomic assumptions. Furthermore, these underlying macroeconomic assumptions have variad dramatically over the most recent easing eyele. How isa relative valve trader supposed to respond to these realities? This section suggests four steps to ‘incorporating macro awareness info selaive value trading “The Girt sip i 1 augment staistical and market flow analysis with an understanding of the ‘implicit macraeconomisassumgrions ina trade and its hedge constriction. This means that making a decision to sell Ss and hedge with an even weiahted portfolio of 2s and 10 on, ‘May 23, 2003, based on analysis of sent rate history must be supplemented with an ‘understanding that the hase case or mean-teverting value ofthe iy and these particular hedge ratios are predicated on a particularly slow speed of economic recovery and particulary great smvermedsate- term uncertain ‘The second step is to have a view about likely regime shifts As of May 23, 2003, for ‘example, itwas reasonable to believe that the very slow spasd af recovery implied by the ‘market was not sustainable, In other words, a significant regime shift isk at chat time was that any favorable economie news would be accompanied by a increase inthe perceived speed of economic ecavery ‘The third step in making eelmive valu trades more macro-aware isto favor trades that have les regime shaft risk, where trades can be favored both in deciding whether to initiate a trade and m how to sealea trade, Consider, for example, two possible situations as of May 28, 2003. LEmasket dows have made Ss rich relative te their very recent history, selling Seis a ‘wane ftom two perspectives. Fist, they are relative-value ich. Second, the trade wall ‘well in the likely repime shift, that i, sm an sncrease in the pereetved speed of economic recovery. By contrast, ifmacket lows have made Ss cheap relative to their very receut history, buying 5s ie uot nearly ae atractive, While they are elative-valve cheap, the trade ‘wll fare poorly in the ikely regime shift. To summarize, arader taking account of regime hid cisk on May 23, 2003, would establish sizeable short postions in Se when they appear ‘ich but would not establich samlarly lage long positions mn Se when they appear cheap, ‘The fourth and final step 35 ro buy option protection against the risk of a specific regime shift Asof May 23, 2003, for exemple, the risk of an increase in the speed of recovery could be hhedged with a combination of options that profit in a flattening sell-off Since a trader or a group of traders often view the world wna particular way, whether informally or through particular term structure modo, mony of their wades at any particular tia are Bikely 10 be ‘exposed tothe same repime shift sk. Viewed this way, option protection can be used fora ‘wading book as a whole and not ust for an indwidual wade, Fusbermore, any cost of this protection shouldbe subtracted fem expected trading gains to determine the true expected profitability ofthe relative value trading enterprise. marogme ana ngrgnca sme Lana Naat Foca ur, a suscavem cs, ‘Detober 2005 3