Politico Trade

May 3, 2012 THE CONCEPT In the period directly following the presidential election and through the end of January, 2013 the United States will have to confront a number of issues related to the deficit. These issues may include: (1) The mandatory deficit reduction measures to be implemented as of January 2013 (2) The repeal of the Bush tax-cuts and (3) Whether or not to raise the debt ceiling yet again. I expect that the political brinkmanship surrounding said issues will result in significant market dislocations.1 Using this past years debt-ceiling debacle as a reference, we can make educated guesses on how markets will behave and compare those against the expectations implied by prices of various financial instruments. ANALYITCAL APPROACH If history does indeed rhyme than the market dislocations during the conflict over raising the debt ceiling should provide fair context for estimating the change in the statistics of any asset class we choose to observe. However, before we pull the data, it is important that we do our best to isolate the effects stemming from the debt-ceiling crisis from those of the crisis in Europe. Otherwise we run the risk of conflating the effects and probably overstating our expected return. To that end, I propose we observe the performance of the USDJPY over the period of July to August. The thinking being that because they are both viewed as safe-haven currencies, investors would be approximately indifferent between holding either in the face of European uncertainty. If this is correct, the cross should roughly but sufficiently mute the noise emanating out of the Europe. In addition, we can compare USDJPY to EURUSD and determine what if any stress was emanating out of Europe at the time. Combining our analysis of the crosses with the historical record, we can attempt to estimate the period from which to draw our conclusions on the debt-ceilings affect on the market. Returning to the USDJPY, observe that there was significant volatility in the period from July 7th to July 17th when the YEN rallied roughly 5.5% against the dollar in only 17days. Then in the period surrounding August 5th, the day the United States was officially downgraded by S&P, we witnessed a significant sell-off followed by an equally spectacular rally.
1

http://thehill.com/homenews/house/224171-congress-punt-lame-duck-high-anxiety

Looking at the EURUSD cross, we can observe that there was relatively little volatility in the period from July 1 to August 20th, followed by a significant sell-off at tail-end of August into September. This is consistent with my recollection and the historical record; (See figures 1&2) that European trouble was not the major factor in the prevailing bias until mid-late August 2011.

Given what weve observed in the USDJPY and EURUSD crosses, I think July 2nd to August 10th is a reasonable period to extract data from. Having defined the relevant, period we can now choose among assets classes and observe their historical behavior. You can choose to look at any asset class you wish but for the sake of liquidity and simplicity, I have chosen to look at the realized volatility in following:
XAUUSD (Spot Gold) SPX Index (S&P 500) USDJPY EURUSD USSG10YR (10yr US Treasury) USSW10 (10yr Swap Spread) AUDNZD CADNOK

Change in Realized Vol (7/2/11 -8/10/11)

Asset XAUUSD SPX Index USDJPY EURUSD USGG10YR USSW10 AUDNZD CADNOK

1Month %Change 69.89% 122.46% 57.95% 32.50% 71.42% 116.87% 34.51% 34.93%

2M %Change 14.47% 105.10% 27.48% 13.98% 75.96 67.55% 9.04% 18.14%

3M %Change 11.82 101.31% 11.03% 15.79% 41.93% 54.08% 12.34% 15.22%

Now that we have the historical data, I break down our expected future parameters into three scenarios: S1, S2, S3 - corresponding to 25%, 50% and 75% of the realized volatility. Going forward said, scenarios will serve to approximate our confidence level that the assumptions underlying the trades hypothesis are valid.

(See Table 1.00)

WHAT CAN GO WRONG In my investment career I operated under the assumption that all investment theses are flawed George Soros

Without even looking at price, we can note that this trade is subject to three significant assumptions: The first being what I term the assumption of brinkmanship: that the political environment will be as tumultuous as it was in the summer of 2011. Personally, I feel confident that politicians will subject the market to a theater similar to the one we witnessed this summer. The players and their motivations have not changed and so I see no reason why the second act should be any different that the first. One caveat to the above statement would be that the players will in fact be subject to change following the election. Whether or not the republicans or democrats are able to take the White House and/or gain a majority in the House will have a significant impact on people expectations for a deal in 2013.2 Considering the aforementioned possibility naturally brings us to the assumption of timing: namely, it is possible that the uncertainty about this uncertainty could move the volatility into the period before the election ends. And thus we must consider the possibility that even if we are correct in the assumptions of brinkmanship and magnitude; bad timing may leave us without a profit to show for it.

The third is the assumption of magnitude: the assumption that the turmoil will produce effects in magnitude similar to we observed in 2011, within this assumption I would posit two subcomponents: o If we believe the market is has learned something from the previous debt-ceiling crisis, namely that the world doesnt end, then we might expect the effects of this, act two to be significantly muted.

o The fitness of our comparisons; the question of mandatory deficit reduction applies to the same issues the debt-ceiling did but it really isnt the same as the possibility of a pending default and possible loss of AAA status by the worlds largest debtor. At the same time, if enacted these deficits are likely to result in a mild to serve recession.3 Furthermore, it is probable the debt ceiling will come up for re-raising during the same period, again. In the end, reasonable minds will differ on the strength of all assumptions and to extent that we find ourselves in doubt of them we should handicap our expectations so as to provide ourselves a margin of safety.

2 3

http://thehill.com/homenews/house/224171-congress-punt-lame-duck-high-anxiety http://video.ft.com/v/1569445003001/Facing-the-fiscal-cliff

Of course the ultimate arbiter of value (risk/reward) is price. At the right price we will require minimal faith in our hypothesis, and with maximum faith in our hypothesis we should still require an attractive price.

EVALUATION (Unfortunately I could not get market pricing for the structures I originally wanted.)
Because forward starting volatility agreements are fairly exotic instruments, I have been unable to obtain any of the forward pricing I wanted to use as a point of comparison. Luckily, through a friend of a friend, I was able to get an indicative level for a SPX 3month variance swap 6months forward. Therefore I will attempt to evaluate the trade in this limited context. On 5/1/12 I was quoted a strike of 23.7%Vol.4, which means that to make money, our realized 3montth Vol would have to be above 23.7% at expiry.

SPX Index 3M Realized Expected Realized 3M Vol 3month Variance Swap Strike Expected Return
SPX Index 101.31% 23.7% 77.61%

25%

50%

75%

S1
25.33% 23.7% 1.63%

S2
50.66% 23.7% 26.96%

S3
75.98% 23.7% 52.28%

The table tells us that if we observe a move 1/4th the size of what we saw last summer over the period of our option we should realize a profit at expiry of approximately 1.63%. Personally, I think this is ok but by no means an outstanding bargain. 3M Realized
101.31% 23.70% 77.61%

10%
10.13% 23.70% -13.57%

25%
25.33% 23.70% 1.63%

Looking at it another way, we would need a strike of 10.13%Vol to be breakeven on a move 1/10th of what we witnessed this summer. With trailing-average realized 3month

http://en.wikipedia.org/wiki/Variance_swap

Vol as of 5/2/12 at 13.78 it seems quite possible that the strike could drift lower giving us the opportunity enter at more attractive levels.

CONCLUSION
All things considered I wouldnt feel comfortable owning anything with a breakeven / strike above the 25% scenario (S1). And despite having strong conviction in the thesis, I would only be comfortable with a small position on at the 23.7%. That being said, I think the risk/reward improves with increasing rapidity as the strike moves from the 25 to 10% confidence level; so I would keep my eye on the market and scale into the trade if it drifts down, all else being equal. Were I not constrained by lack of pricing; I would look at two types of trades across assets classes. The first being trades that allow us to remain agnostic about the outcome and merely focus on the volatility surrounding the process. The second would be trades that are contingent on the additional assumption that the effects of this second debt-debate will be similar both in magnitude and direction to what we observed earlier this summer. Said pricing would allow for relative value analysis and more exotic structures but unless it becomes available, we will have to wait until we believe more vanilla instruments can employed. Tables two and three offer an approximation of how I would use pricing to determine absolute and relative value of various instruments:

(See Table 2.00) (See Table 3.00)

FIGURES & TABLES: Table 1.00

Expected Realized 1M Vol
Asset XAUUSD SPX Index USDJPY EURUSD USGG10YR USSW10 AUDNZD CADNOK 1M Realized %Change 69.89% 122.46% 57.95% 32.50% 71.42% 116.87% 34.51% 34.93% S1 17.47% 30.61% 14.49% 8.13% 17.86% 29.22% 8.63% 8.73% S2 34.95% 61.23% 28.98% 16.25% 35.71% 58.43% 17.25% 17.47% S3 52.42% 91.84% 43.46% 24.38% 53.57% 87.65% 25.88% 26.20%

Expected Realized 2M Vol

Asset XAUUSD SPX Index USDJPY EURUSD USSG10YR USSW10 AUDNZD CADNOK

2M Realized %Change 14.47% 105.10% 27.48% 13.98% 75.96% 67.55% 9.04% 18.14% 3M Realized %Change 11.82% 101.31% 11.03% 15.79% 41.93% 54.08% 12.34% 15.22%

S1 3.62% 26.28% 6.87% 3.50% 18.99% 16.89% 2.26% 4.54% S1 2.96% 25.33% 2.76% 3.95% 10.48% 13.52% 3.09% 3.81%

S2 7.24% 52.55% 13.74% 6.99% 37.98% 33.78% 4.52% 9.07% S2 5.91% 50.66% 5.52% 7.90% 20.97% 27.04% 6.17% 7.61%

S3 10.85% 78.83% 20.61% 10.49% 56.97% 50.66% 6.78% 13.61% S3 8.87% 75.98% 8.27% 11.84% 31.45% 40.56% 9.26% 11.42%

Expected Realized 3M Vol

Asset XAUUSD SPX Index USDJPY EURUSD USSG10YR USSW10 AUDNZD CADNOK

Figure 1.00
On 1 January, Estonia joins the euro, taking the number of countries with the single currency to 17. In February, eurozone finance ministers set up a permanent bailout fund, called the European Stability Mechanism, worth about 500bn euros. In April, Portugal admits it cannot deal with its finances itself and asks the EU for help. In May, the eurozone and the IMF approve a 78bn-euro bailout for Portugal. In June, eurozone ministers say Greece must impose new austerity measures before it gets the next tranche of its loan, without which the country will probably default on its enormous debts. Talk abounds that Greece will be forced to become the first country to leave the eurozone. In July, the Greek parliament votes in favour of a fresh round of drastic austerity measures, the EU approves the latest tranche of the Greek loan, worth 12bn euros. A second bailout for Greece is agreed. The eurozone agrees a comprehensive 109bneuro ($155bn; 96.3bn) package designed to resolve the Greek crisis and prevent contagion among other European economies. In August, European Commission President Jose Manuel Barroso warns that the sovereign debt crisis is spreading beyond the periphery of the eurozone. The yields on government bonds from Spain and Italy rise sharply - and Germany's falls to record lows - as investors demand huge returns to borrow. On 7 August, the European Central Bank says it will buy Italian and Spanish government bonds to try to bring down their borrowing costs, as concern grows that the debt crisis may spread to the larger economies of Italy and Spain.

The G7 group of countries also says it is "determined to react in a co-ordinated manner," in an attempt to reassure investors in the wake of massive falls on global stock markets. During September, Spain passes a constititional amendment to add in a "golden rule," keeping future budget deficits to a strict limit. Italy passes a 50bn-euro austerity budget to balance the budget by 2013 after weeks of haggling in parliament. There is fierce public opposition to the measures - and several key measures were watered down. The European Commission predicts that economic growth in the eurozone will come "to a virtual standstill" in the second half of 2011, growing just 0.2% and putting more pressure on countries' budgets. Greek Finance Minister Evangelos Venizelos says his country has been "blackmailed and humiliated" and a "scapegoat" for the EU's incompetence. On 19 September, Greece holds "productive and substantive" talks with its international supporters, the European Central Bank, European Commission and IMF. The following day, Italy has its debt rating cut by Standard & Poor's, to A from A+. Italy says the move was influenced by "political considerations".

-(Source BBCNews: http://www.bbc.co.uk/news/business-13856580)

Figure 2.00
Debt Ceiling Timeline June 23, 2011: Biden's negotiations on the debt ceiling were cut off when both Eric Cantor and Jon Kyl walk out over disagreements on taxes.[147]

July 19, 2011: The Republican Majority in the House brought the Cut, Cap and Balance Act (H.R.2560),[148] their proposed solution to the crisis, to a vote. They passed the bill by a vote of 234190, split closely along party lines: 229 Republicans and 5 Democrats 'for', 181 Democrats and 9 Republicans 'against'; it was sent to the Senate for consideration. The Bill authorized that the debt ceiling be raised by $2.4 trillion after a Balanced Budget Amendment was passed by Congress. Since Constitutional amendments require a two-thirds majority vote in both chambers of Congress to pass, a vote for a Balanced Budget Amendment would require more support than the Cut, Cap and Balance Act bill achieved in the House vote.[149] July 22, 2011: The Senate voted along party lines to table the Cut, Cap and Balance Act; 51 Democrats voting to table it and 46 Republicans voting to bring it to a debate.[150] Senate Majority Leader Harry Reidcalled the Act "one of the worst pieces of legislation to ever be placed on the floor of the United States Senate." Even had it passed Congress, Obama had promised to veto the bill.[151] July 25, 2011: Republicans and Democrats outlined separate deficit-reduction proposals.[9] July 25, 2011: Obama and Speaker of the House John Boehner addressed the

nation separately over network television with regards to the debt ceiling.[152]

July 25, 2011: The bond market is shaken by a single $850 million futures trade betting on US default. July 29, 2011: The Budget Control Act of 2011 S. 627,[153] a Republican bill that immediately raised the debt ceiling by $900 billion and reduced spending by $917 billion, passed in the House on a vote of 218210. No Democrats voted for it, and it also drew 'no' votes from 22 Republicans, who deemed it insufficiently tough on spending cuts.[154] It allows the President to request a second increase in the debt ceiling of up to $1.6 trillion upon passage of the balanced-budget amendment and a separate $1.8 trillion deficit reduction package, to be written by a new "joint committee of Congress."[155] Upon introduction into the Senate in the evening, the bill was immediately tabled on a 5941 vote, including some Republican votes.[156] July 30, 2011: The House of Representatives voted 173246 to defeat Senate Majority Leader Harry Reid's $2.4 trillion plan to reduce the deficit and raise the debt ceiling.[157] July 31, 2011: President Barack Obama announced that leaders of both parties had reached an agreement to lift the debt ceiling and reduce the federal deficit. Separately, House Speaker John Boehner told Republicans that they had reached the framework for an agreement.[158] Boehner revealed details of the agreement in a presentation to the House Republicans.[159] August 1, 2011: The House passed a bipartisan bill by a vote of 269161. 174 Republicans and 95 Democrats voted 'yes'; 66 Republicans and 95 Democrats voted 'no'.[160] August 2, 2011: The Senate passed the bill by a vote of 7426. 28 Republicans, 45 Democrats, and 1 independent voted 'yes'; 19 Republicans, 6 Democrats, and 1 independent voted 'no'.[161] President Obama signed the debt ceiling bill the same day, thus ending fears of a default. Obama also declared that the bill is an "important first step to ensuring that as a nation we live within our means."[162] August 2, 2011: The date estimated by the Department of the Treasury that the borrowing authority of the US would be exhausted, if the debt ceiling crisis were not resolved.[3] August 5, 2011: Standard & Poor's lowered the credit rating of the United States from AAA to AA+,[109][112] deciding that the budget plan that was passed did not go far enough to address the country's debt. It also warned that it is pessimistic about the nation's fiscal outlook.[163] August 9, 2011. The US Federal Reserve announced it will keep interest rates at "exceptionally low levels" at least through mid 2013; it made no commitment for further quantitative easing. (Reuters) TheDow Jones Industrial Average and the New York Stock Exchange as well as other world stock markets, recovered after recent falls. (Wall Street Journal) August 15, 2011: The date estimated by the Fitch rating agency and the FRBNY primary dealer Jefferies & Co that $29 billion of federal debt interest

would have become due, thus triggering a technicalsovereign default if the debt ceiling crisis had not been resolved. This, however, did not occur as the debt ceiling crisis was resolved by then.[164][165] -(Source: http://en.wikipedia.org/wiki/United_States_debt-ceiling_crisis)

Table 2.00
XAUUSD Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return 1M Realized
XAUUSD 69.89%

S1
17.47%

S2
34.95%

S3
52.42%

2M Realized
XAUUSD 17.47%

S1
4.37%

S2
8.74%

S3
13.10%

3M Realized
XAUUSD 11.82%

S1
2.96%

S2
5.91%

S3
8.87%

SPX Index Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle

1M Realized
SPX Index 122.46%

S1
30.61%

S2
61.23%

S3
91.84%

2M Realized
SPX Index 105.10%

S1
26.28%

S2
52.55%

S3
78.83%

Expected Return 3M Realized Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return
SPX Index 101.31%

S1
25.33%

S2
50.66%

S3
75.98%

USDJPY Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle Expected Return

1M Realized
USDJPY 57.95%

S1
14.49%

S2
28.98%

S3
43.46%

2M Realized
USDJPY 27.48%

S1
6.87%

S2
13.74%

S3
20.61%

3M Realized Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return
USDJPY 11.03%

S1
2.76%

S2
5.52%

S3
8.27%

EURUSD Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol

1M Realized
EURUSD 32.50%

S1
8.13%

S2
16.25%

S3
24.38%

2M Realized
EURUSD 13.98%

S1
3.50%

S2
6.99%

S3
10.49%

Implied Break-Even ATM Vol 2m Straddle Expected Return 3M Realized Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return
EURUSD 15.79%

S1
3.95%

S2
7.90%

S3
11.84%

AUDNZD Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return

1M Realized
AUDNZD 34.51%

S1
8.63%

S2
17.25%

S3
25.88%

2M Realized
AUDNZD 9.04%

S1
2.26%

S2
4.52%

S3
6.78%

3M Realized
AUDNZD 12.34%

S1
3.09%

S2
6.17%

S3
9.26%

USGG10YR Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return

1M Realized
USGG10YR 71.42%

S1
17.86%

S2
35.71%

S3
53.57%

2M Realized

S1

S2

S3

Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle Expected Return

USSG10YR

75.96%

18.99%

37.98%

56.97%

3M Realized Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return
USSG10YR 41.93%

S1
10.48%

S2
20.97%

S3
31.45%

USSW10 Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Straddle Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Straddle Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return

1M Realized
USSW10 116.87%

S1
29.22%

S2
58.43%

S3
87.65%

2M Realized
USSW10 67.55%

S1
16.89%

S2
33.78%

S3
50.66%

3M Realized
USSW10 54.08%

S1
13.52%

S2
27.04%

S3
40.56%

Table 3.00
XAUUSD Expected Realized 1M Vol 1M Realized
XAUUSD 69.89%

S1
17.47%

S2
34.95%

S3
52.42%

Implied Break-Even ATM Vol 1m Call Expected Return 2M Realized Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Call Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Call Expected Return
XAUUSD 17.47%

S1
4.37%

S2
8.74%

S3
13.10%

3M Realized
XAUUSD 11.82%

S1
2.96%

S2
5.91%

S3
8.87%

SPX Index Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Put Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 1m Put Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 1m Put Expected Return

1M Realized
SPX Index 122.46%

S1
30.61%

S2
61.23%

S3
91.84%

2M Realized
SPX Index 105.10%

S1
26.28%

S2
52.55%

S3
78.83%

3M Realized
SPX Index 101.31%

S1
25.33%

S2
50.66%

S3
75.98%

USGG10YR Expected Realized 1M Vol

1M Realized
USGG10YR 71.42%

S1
17.86%

S2
35.71%

S3
53.57%

Implied Break-Even ATM Vol 1m Call Expected Return 2M Realized Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Call Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Straddle Expected Return
USSG10YR 75.96%

S1
18.99%

S2
37.98%

S3
56.97%

3M Realized
USSG10YR 41.93%

S1
10.48%

S2
20.97%

S3
31.45%

USSW10 Expected Realized 1M Vol Implied Break-Even ATM Vol 1m Call Expected Return Expected Realized 2M Vol Implied Break-Even ATM Vol 2m Call Expected Return Expected Realized 3M Vol Implied Break-Even ATM Vol 3m Call Expected Return

1M Realized
USSW10 116.87%

S1
29.22%

S2
58.43%

S3
87.65%

2M Realized
USSW10 67.55%

S1
16.89%

S2
33.78%

S3
50.66%

3M Realized
USSW10 54.08%

S1
13.52%

S2
27.04%

S3
40.56%