Ratelab Vol Heads South

Value Concepts from the BAS/ML Trading Desk August 27, 2009

Implied Volatility Heading South for the Winter U

Our previous RateLab – “Long Live the King (Bernanke)” August 26, 2009 detailed the implications of another four years of a Bernanke FED. In summary, his well advertized plans for conducting Monetary Policy should reduce uncertainty and Volatility in the market. This will most likely result in a reduction in the recent record levels of Implied Volatility. This RateLab will detail our thought process and recommend an idea. The –blue line- below should be recognizable to all; it’s our famous MOVE Index. To refresh your memory, the MOVE Index is the blended Implied Normalized Volatility for one month options across the Treasury Curve. It is available on

All charts, unless otherwise noted, are sourced from BAC/MER data

1

Bloomberg via the function: MOVE Index gp The MOVE most recently closed at 126 which roughly translates into a daily move of 8bps. Although this is down considerably from the June average of 172, it is still well above its 21 year average of 104 (6.5bps/day). Presently, almost all options activity is being conducted via swaptions. Therefore, swaptions are a much better measure of Implied Volatility and the cost of Convexity risk. The –orange line- below is the Implied Volatility of the benchmark 6 month into 10yr swaption.

2

Its recent close was 160 Nvol or 10bps a day. This is about 2.2 Standard Deviations above its 15 year average of 108 Nvol. Since the Yield Curve has been so volatile, many traders prefer to look at the cost of Convexity for other “tails”. In the chart above, the –green line- is the 6 month into 2 year Implied Volatility while the –red line- is the 3 month into 5 year Implied Volatility. The 6m-2y closed at 134Nvol versus its 15 year average of 110Nvol while the 3m-5y closed at 165Nvol versus its long-term average of 114Nvol. Short-dated “gamma” options often explode in price during a time of stress. However, this time the entire Volatility surface rose. Below, the –purple line- is the Implied Volatility for 2 year into 10 year swaptions, one of the MBS Vega benchmarks. Also below is the -maroon line-, the 5 year into 5 year benchmark.

Although Implied Volatilities have declined from the mega highs set in June, they are still 25% to 45% above their lifetime averages. However, this alone does not support entering a risk taking trade. We need a bit more meat. Implied Volatility is most strongly correlated with Actual (or Realized) Volatility. Implied Vol (via time decay) is the rent paid for an option while Realized Vol is the income generated by “delta” hedging; these two must converge over time in order to eliminate arbitrage profits. Although one tends to lead the other at various times, over many weeks, Implieds track Actuals quite well. In the chart below, we compare the Implied Volatility of 3m – 10yr (–blue line-) and 6m – 10y (–green

3

line-) versus the –red line- of Actual Volatility. Notice how the declining Actual Vol is pulling Implied Volatility lower. Everyday that the Implied Volatility is above Actual Volatility, the option longs are losing money, i.e., their theta losses are greater than their hedging gains.

So the question is: Why should we expect Actual Volatility to decline even further ?

4

Although the cycles can sometimes be quite long, many markets tend to exhibit a “Regression Towards the Mean” (RTM). The RTM effect is why the Yield Curve twists in response to FED action. It is also why the Volatility Surface is negatively sloped from the mid-expiry point to the long-expiry point. Most critically, it is why distant Forward rates tend to be much less volatile than Spot rates. Following this logic, the chart above indicates that the Rates market may have finally found its level and might settle down for awhile. The –green line- is the 1 year rate reflected 5 years forward. Similarly, the –blue line- is the 5 year rate 5 years forward while the –pink line- is the 2 year rated projected 10 years forward. Not only have all these converged to about 4.90%, but also this level is within 30bps of their five year average of 5.20%. It is likely that the markets have listened carefully to Bernanke and are starting to develop a consensus as to the long-term level of rates. This does not mean that the market is right, it simply implies that markets will probably stabilize until new information is introduced. Specifically, how and when will the stimulus be removed. But as noted yesterday, that event is most likely a distant one. Finally, we at the RateLab are particularly fond of looking at large liquid markets to take our queues instead of volatile illiquid ones. The MBS market is the world’s largest bond sector and this is where “real money” most clearly speaks. The –pink line- below is the Libor OAS for the Par MBS bond. It is presently at -10bps. However, if Volatility declines by the 20% we predicted in the last RateLab, all else equal, our analytics will produce an OAS of +10bps. That is equal to the prebubble average set during 2001 to 2003. In a nutshell, it seems as if the huge

5

MBS market has already priced in the fair market valuation before the less liquid swaptions market had a chance to vote.

Conclusion Markets are traded by people, not machines; and a person’s ability to absorb risk and anxiety is limited. This is why ultra volatile markets eventually calm down traders become exhausted and close out their risky positions. Although it certainly felt as if the world was going to end, the reality was: This too will pass. It is now seeming more and more likely that although Bernanke may not be able to guarantee a good ending, at least he can make the path there less bumpy. As such, both Actual and Realized Volatility should slowly decline. Six month 10yr Implied Vol is too high; it can decline by 20% and still be a full Standard Deviation above its lifetime average. We recommend selling 6m to 2yr expiries on 5yr to 10yr tails.

Trade Idea Sell 200mm 6m-10y -75bp rcv k = 3.15% Buy 100mm 6m-10y atm std k = 3.90% Sell 200mm 6m-10y +75bp pyr k = 4.65% Pay $1.875mm net selling 155Nvol Harley S. Bassman BAS/ML US Trading Desk Rates Strategy August 27, 2009

Important Note to Investors The above commentary has been created by the Rates Strategy Group of Banc of America Securities LLC (BAS) for informational purposes only and is not a product of the BAS or Merrill Lynch, Pierce, Fenner & Smith (ML) Research Department. Any opinions expressed in this commentary are those of the author who is a member of the Rates Strategy Group and may differ from the opinions expressed by the BAS or ML Research Department. This commentary is not a recommendation or an offer or solicitation for the purchase or sale of any security mentioned herein, nor does it constitute investment advice. BAS, ML, their affiliates and their respective officers, directors, partners and employees, including persons involved in the preparation of this commentary, may from time to time maintain a long or short position in, or purchase or sell as market-makers or advisors, brokers or commercial and/or investment bankers in relation to the securities (or related securities, financial products, options, warrants, rights or derivatives), of companies mentioned in this document or be represented on the board of such companies. BAS or ML may have underwritten securities for or otherwise have an investment banking relationship with, companies referenced in this document. The information contained herein is as of the date referenced and BAS and ML does not undertake any obligation to update or correct such information. BAS and ML has obtained all market prices, data and other information from sources believed to be reliable, although its accuracy and completeness cannot be guaranteed. Such information is subject to change without notice. None of BAS, ML, or any of their affiliates or any officer or employee of BAS or ML or any of their affiliates accepts any liability whatsoever for any direct, indirect or consequential damages or losses from any use of the information contained in this document. Please refer to this website for BAS Equity Research Reports:

http://www.bankofamerica.com/index.cfm?page=corp H

H

6