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craig_ferguson


Total Posts: 3
Joined: Mar 2022
 
Posted: 2022-03-07 23:34
Hi all,

I recently started working on a delta one trading desk on a sell side bank where we trade RevCons on hard to borrow stocks (GME, ARKG, ARKK etc). The desk is essentially a prop desk taking views on the borrow rates of these stocks by putting on these positions.

For those who don’t know, a conversion in the rev-con market is when you buy the underlying while simultaneously going short synthetically via options to a specific maturity date. By doing that, the desk is able to lock in a implied borrow rate and from there, the stock loan desk loans out the shares. The difference between the stock loan rate and the rate we locked in over the life of the options is the profit.

Long story short, since we are trading large amounts of these options that are long dated, interest rate risk comes into play. I have been trying to find material online how I can hedge this risk correctly but I have ran into a brick wall. It also doesn’t help that the people on my desk don’t have a good solution either.

So far what I have done is calculated the overall Rho position of the portfolio and from there, bucketed the values into expiration date pillars. From my understanding, if you divide Rho by 100, you get the DV01 of the equity option position.

The next logical step in my head is to then hedge the Bucketed DV01 risk via interest rate swaps to that specific expiration date which in turn, will neutralize the DV01 risk.

Does anyone know if I am on the right track? I would greatly appreciate it if anyone has any insight, materials or comments on my thinking so far.

Thank you.

nikol


Total Posts: 1474
Joined: Jun 2005
 
Posted: 2022-03-08 08:31
Under delta-one apart from IRate you also run dividend/coupon and credit risk and hence funding. Dig into Total Return Swaps, Asset swaps (maybe CDS) mechanics. It will help.

... What is a man
If his chief good and market of his time
Be but to sleep and feed? (c)

silverside


Total Posts: 1458
Joined: Jun 2004
 
Posted: 2022-03-08 09:49
I believe you are on the right track

however I am not so sure that the interest rate risk you want to hedge is the "risk-free" interest rate (the USD swap rate).

From your explanation, you are essentially trading the borrow-rate against the implied discount rate from the options market. The borrow-rate is a short term rate which is rolled over, whereas the options market discount rate has a term structure aligned to the options maturity. Do I have that right ?

if you hedge the short term rate risk (with USD LIBOR futures or whatever the flavour of the day is) and the long term risk (with swaps) you are still left with spread risk ?

Are these trades marked-to-market / collateralised and how are they valued ?

ronin


Total Posts: 708
Joined: May 2006
 
Posted: 2022-03-08 11:01
What @silverside sad, but it sounds like there is a bit more to it.

The trade that you describe shouldn't have any option rho. It's a funding trade. And the only dv01 you would be seeing would be on an uncollateralized leg. But why is there an uncollateralized leg?

Unless there is some basis beween the collateral rates on the cash and derivatives side. But that would make for a more complicated basis, not outright dv01.

You probably want to draw some funding diagrams, and work out what the net position is.

And here is the thing. Knowing absolutely nothing about this desk and where it is.

My wild guess is that, what ever profit the desk has, it would be wiped out if you hedge what ever exposure you are seeing. It's some carry trade where you are running the steepness of the curve.

"There is a SIX am?" -- Arthur

chiral3
Founding Member

Total Posts: 5233
Joined: Mar 2004
 
Posted: 2022-03-08 12:43
You are running a fairly common strategy, i.e., running a funding carry trade against your borrowing rates. Seems that you want to take some interest rate risk as when you say “long dated” I assume they aren’t super long; or rather even if you have some longer maturities there’s not that much notional behind the longer ones. Sitting on PAYers in an inflationary scenario is going to eat away at your funding spread which, since you mention this is on hard-to-borrows, is probably somewhat tenuous to begin with.

D1 desks have gotten creative in this department. I know one major shop that uses their own executive compensation plan to hold hard to borrow for the purpose of swaps and occasionally single stock options (versus being subject to spikes in repo say). Seems like you would just want to calculate some dv01s and KRDs and manage some longer dated positions to a tail, maybe a VaR or better yet a TVaR.

Русский военный корабль, иди на хуй!

craig_ferguson


Total Posts: 3
Joined: Mar 2022
 
Posted: 2022-03-10 03:31
Hi all. Thanks for your responses. I am super convinced that you guys have the knowledge that I am looking for. I have been chatting with the people on my desk and to be honest, we still don’t have a solid answer… also sorry for replying to this message only, I couldn’t figure out how to just post a new comment on the thread.

That said, I’d like to give an example trade and see how you guys interpret it.

Example: I buy 10k contracts of a 1 year AAPL, $190 strike conversion paying 0.25$ to convert when AAPL spot is trading at $190. Aka I have to pay 0.25$ per share to borrow AAPL over the life of the trade.

Now say we have an empty portfolio and the desk has no cash laying around to use. Originally, I thought I would need to borrow $190mm in cash to purchase the shares + 250k to pay for the options at say 7bp from my internal desk. That said, if this were the case, I am 99% sure that my interest rate risk from borrowing the cash for the equity purchase AND the RHO exposure from the options would be tied directly to the rate at which I borrow internally, and In order to hedge this, I could put on a fixed vs floating swap for the term of the trade. To me, this makes sense.

Unfortunately, it seems in reality this not the case. Now according to some people on my desk, We fund the purchase of the AAPL equities by actually lending out THOSE shares in the stock loan market. By doing this, we get the face value of the shares ($190mm USD + the cash we receive from the rate at which we loan the stock at). That said, I was told that the cash we get in return is than used to pay for the option positions (0.25$ per share)…

Now if that was the case, wouldn’t my Rho exposure from my options be tied to the rate at which we loan the actual AAPL equities at?

As you can tell, I am super confused on the dynamics of these types of trades and I would be super thankful if anyone can help me further on this topic.

Thank you so much!

ronin


Total Posts: 708
Joined: May 2006
 
Posted: 2022-03-10 09:37
I don't think the example works. You are supposed to short delta with the options, and there you are buying calls. And then buying stock as well. You are going long stock twice, instead of going long on one leg and short on the other.

The option rho is what you would have on the 250k. If rates go up, forward goes up and the call goes ITM. That's option rho.

The funding for shares would be floating, not fixed. There would be dv01 on the spread, but not on the entire leg.

Can you re-think this example?

"There is a SIX am?" -- Arthur

craig_ferguson


Total Posts: 3
Joined: Mar 2022
 
Posted: 2022-03-10 11:24
Hi @ronin. Sorry if I wasn’t clear but when I said I convert 10k AAPL I meant I was going long the shares and then paying a net cost of 0.25$ To go synthetically short AAPL at a strike of $190 indicating cost of puts is 0.25$ more than the call. This is a typical position we would put on but usually we’d convert hard to borrow names not stocks like AAPL (in the revcon market, you’d get paid to convert AAPL).

That said, I do agree that the funding for the shares would be floating as day over day, the rate I pay internally can change. Regardless of how I fund the shares, can you please elaborate on what you mean by “there would be DV01 on the spread but not entire leg”?

It sounds like you are alluding to what you mentioned in your first post: “
Posted: 2022-03-08 10:01
The trade that you describe shouldn't have any option rho. It's a funding trade. And the only dv01 you would be seeing would be on an uncollateralized leg. But why is there an uncollateralized leg?

Unless there is some basis beween the collateral rates on the cash and derivatives side. But that would make for a more complicated basis, not outright dv01.”

If you don’t mind can you please give and example like I did which should help me connect the dots. Again, thank you for time. I really appreciate it.

ronin


Total Posts: 708
Joined: May 2006
 
Posted: 2022-03-10 16:16
> “there would be DV01 on the spread but not entire leg”?

You fund at OIS plus something. Say OIS + 5 bp. OIS has no dv01, but a fixed leg of 5 bp has a dv01. You have dv01 on the 5 bp spread.

> I meant I was going long the shares and then paying a net cost of 0.25$ To go synthetically short AAPL at a strike of $190 indicating cost of puts is 0.25$ more than the call.

I finally got that example - it had me confused at first...

It's easier if you just draw all of these legs on a whiteboard. When they all cross out, it ends with you paying OIS plus spread on $190 mln plus option premium, and making the swap rate on $190 mln plus option premium.

That is called running the carry. Carry = swap - OIS in this case. If you swapped the swap rate for OIS (i.e. hedged the interest rate risk), your pnl would be zero minus all the extra costs.

Instead, you are running with the fact that OIS is now less than the swap rate and you hope it stays that way. You are being paid to run the interest rate risk. Only, you are doing it in some creative way. Because your bank isn't allowed to run a large position in swaps outright.

"There is a SIX am?" -- Arthur

GotTheTrumpCard


Total Posts: 1
Joined: Mar 2022
 
Posted: 2022-03-30 07:17
I’ve actually thought about this type of borrow rate trade quite a bit, though have never done it.

I believe the Rho risk should be hedgable via going long rates in swaps/futures, or SPX box spreads; however, the dividend risk is not, unless there is a liquid market for dividend swaps (interestingly, borrow rate and dividends effect the options price the same way, which makes sense because lending your shares for interest is a form of yield).

Also, I’m fairly certain you are implicitly long the stock when creating this position. This is because the option’s implied borrow rate is based on the current price of the shares, say $100, and you pay the borrow rate up front for the duration of the contract, say $1 in extra options premium. But, the $ amount the borrower of the shares will pay = borrow rate * share price. So if the share price falls to $50, but and the borrow rate constant at 1%, your desk will lose $.50 per share. Could be wrong, I don’t have much experience in the securities lending and borrowing (SLB) space.

Anyways, this is a super interesting trade, as it deals with the SLB market, which is probably less efficient then most other markets.

Strange


Total Posts: 1684
Joined: Jun 2004
 
Posted: 2022-04-11 20:14
> The trade that you describe shouldn't have any option rho.

Maybe I am just being stupid...

He's traded a revcon, so now he's long shares, short combo (i.e. short call, long put). Such a position will be exposed to several separate bits of rate risk, with specifics depending on how the trade is done. The long shares would be funded at the firm level via overnight funding. Then there is premium, which would be (a) firm funding for term in case of LLA, (b) consensus funding for term if margined on the exchange or (c) nothing for FP - all of this is negligible for a revcon, so we can ignore it. Finally, there is the exposure to the stock forward that's driven by the consensus funding for term (usually OIS plus something - discoverable via boxes).



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