Sunday, April 12, 2009 Quantology Revisited: The Negative Convexity Implications Of Delta-Hedging
Posted by Tyler Durden at 10:39 AM
I thank readers who provided tremendous insights on the market illiquidity post. However, one point that nobody mentioned, which may very well be at the heart of the problem, has to do with the issue of negative convexity from a delta-hedging perspective. Zero Hedge had previously discussed the implications of this very peculiar phenomenon two months ago in the context of CDO trend chasing in the CDS market and how negative convexity (especially in illiquid markets) leads to explosive and self-fulfilling rallies on either side.
I thank an anonymous reader for presenting the missing piece of the puzzle, and taking the convexity argument one step further from merely structured finance to the entire market. I welcome responses and apologize for the thematic wonkiness, however there is only so much simplification that can be presented. But a simplified attempt: we have crossed into territory where the negative convexity consequences of delta hedging will keep on pushing the market in a straight line in whatever direction it is moving until we see a violent reversal and the delta hedge breaks due to lack of vol to "feed it", which will be, in the parlance of our times, the market's epic fail.
What is good for GS is good for US... Young analysts, just starting in GS the London office not too long ago were told that delta hedging of equity derivatives books can account for up to 30% of market volumes. TD's data clearly demonstrates that vanilla, slow money are being swamped by quant props.
Delta hedging of GS, DB, BNP and other dealers listed/OTC equity derivatives books could be what others construe as a 'sinister plot' to goose up US markets. OTC derivatives are many times bigger than listed and often hedged on listed markets. Clearly many books got caught short upside gamma and that will force them to buy indices and individual names as market goes up. The higher the market goes, the more they need to buy. Markets are getting too small for all the large players to operate efficiently. All of them need to get smaller or some will die.
TD's ideas and data can be taken further and what started as low level liquidity provision issues expanded into market neutral quant problems and spilled in derivatives creating a self-feeding process. More quant problems leads to further short covering, higher markets, further delta hedging, more vanilla, slow money getting sucked in and ever sunnier CNBC commentators and Time magazine contributors. Until, as TD puts it, it doesn't.
Tuesday, April 14, 2009 Merrill Let Loose On The Quant Scent Posted by Tyler Durden at 5:12 PM
In a report released yesterday, it is somewhat gratifying that Merrill Lynch analyst Mary Ann Bartels agrees with Zero Hedge conclusions about possible near-term market volatility events as a result of quant fund deleveraging.
Last week, we noted that our estimate of hedge fund exposure based on factor based analysis suggested L/S HF market exposure may have peaked in the second half of March (top left chart below), after increasing significantly from the record lows of mid-December, and the sharp rise in large speculators’ net long position in S&P 500 futures was a possible hedge. The reduction in market exposure is even more evident among quantitative funds (top right and bottom left charts). Quant fund market xposure appears to have peaked in Feb, but started to fall rapidly in late March, a couple of weeks into the current equity rally. Quant funds, not surprisingly, are down ~-1.9% over the last month. US L/S equity funds have been able to capture more of the month-long move up in equities, gaining 1.3%. But both categories of funds are now pulling back.
The reduction in market exposure may be in part due to quarter-end rebalancing of books, but the readings could be important for two reasons. First, a sharp fall in beta could be a contrarian bullish for equities if HFs are forced back in. Secondly, HFs are an important source of liquidity for the markets - particularly true of quant funds employing high-frequency algorithmic and programming trading strategies. A big drop in HF presence in the equity markets could result in rising volatility.
Significant estimated factor exposures for Equity Market Neutral funds:
* M/N funds’ market exposure further underweights equities. * Growth, large caps and high quality tilts. Positive inflationary expectations.
Significant factor exposure changes since last week:
* Market exposure continues to decline rapidly. * Large caps and High quality tilts rise. Inflationary expectations increase.
And lastly, another chart, this time depicting the Dow Jones Equity Market Neutral Index (DJHFEQMK). Not lookin' too hot.
(20min delay)