Options as an Asset Class

Well, my CDO model is complete for a first pass. There is still more work to do. Imagine buying a security that you thought would mature in ten years, but two years into the deal, you find that the security will mature in twenty years from then, though paying off principal in full, most likely. Worse, the market has panicked, and the security you bought with a 6.5% yield is now getting discounted at a mid-teens interest rate. Cut to the chase: that is priced at 40 cents per dollar of par. Such is the mess in some CDOs today.

Onto the topic of the night. There have been a number of articles on volatility as an asset class, but I am going to take a different approach to the topic. Bond managers experience volatility up close and personal. Why?

  • Corporate bonds are short an option to default, where the equity owners give the company to the bondholders.
  • Mortgage bonds are short a refinancing option. Volatile mortgage rates generally harm the value of mortgage bonds.
  • Even nominal government bonds are short an inflation option, should the government devalue the currency. (Or, for inflation-adjusted notes, fuddle with the inflation calculation.)

Why would a bond investor accept being short options? Because he is a glutton for punishment? Rather, because he gets more yield in the short run, at the cost of potential capital losses in the longer-term.

Most of the “volatility as an asset class” discussion avoids bonds. Instead, it focuses on variance swaps and equity options. Well, at least there you might get paid for writing the options. Bond investors might do better to invest in government securities, and make the spread by writing out-of-the-money options on a stock, rather than buying the corporate debt.

I’m not sure how well futures trading on the VIX works. If I were structuring volatility futures contracts, I would create a genuine deliverable, where one could take delivery of a three month at-the-money straddle. Delta-neutral — all that gets priced is volatility.

Here’s my main point. Volatility is not an asset class. Options are an asset class. Or, options expand other asset classes, whether bonds, equities, or commodities. Whether through options or variance swaps, if volatility is sold, the reward is more income in the short run, at the cost of possible capital losses in asset classes one is forced to buy or sell at disadvantageous prices later.

Over the long term, in equities, unlike bonds, being short options has been a winning strategy, if consistently applied. (And one might need an iron gut to do it.) But when many apply this strategy, the excess returns will dry up, at least until discouragement sets in, and the trade is abandoned. For an example, this has happened in risk arbitrage, where investors are short an option for the acquirer to walk away. For a long time, it was a winning strategy, until too much money pursued it. At the peak you could make more money investing in Single-A bonds. Eventually, breakups occurred, and arbs lost money. Money left risk arbitrage, and now returns are more reasonable for the arbs that remain.

Most simple arbitrages are short an option somewhere. That’s the risk of the arbitrage. With equities, being perpetually short options is a difficult emotional place to be. You can comfort yourself with the statistics of how well it has worked in the past, but there will always be the nagging doubt that this time it will be different. And, if enough players take that side of the trade, it will be different.

Like any other strategy, options as an asset class has merit, but there is a limit to the size of the trade that can be done in aggregate. Once enough players pursue the idea, the excess returns will vanish, leaving behind a market with more actual volatility for the rest of us to navigate.