Have noticed some of the big guys are jockeying around some Ten-year options positions for the last couple weeks, both of them on the opposite side of the spectrum. On the call side, someone (most likely Wells Fargo) was long about 75,000 of the December 110 calls when we were trading at the 113 handle, thus was paying about 3 option handles (almost 200 option ticks) to get some mortgage pre-payment protection. Here is my question, why did he not just buy futures at his predetermined convexity yield level in the 10yr? Guys that know more about options pricing please chime in. He is paying for massive amounts of premium, way too much capital tied up in this trade. Today he began to roll this position into the March 111 calls, taking about a 120 tick loss on average on 15,000 of the calls (has about 60,000 more to roll). On the other hand, a big bond fund (possibly Western Asset Management) rolled his December 106 puts into the March 104 puts a week or two ago, and bought the March 104 puts outright, total of about 80,000. Today, as if we are going to trade 5 points lower in no time he rolled 80,000 March 104 puts into the 102 put strike (has to be against something on the cash 10-year side). Obviously people are worried about volatility on both sides of the table when it comes to early next year. Have seen some weird stuff, but buying 80,000 puts almost 8 handles out of the money has got to be worrisome for guys holding long-end debt. Any thoughts.
The idea behind convexity hedging is that since you are short options in the form of being long MBS, you buy them back at the level where you think prepayments are going to be the most rampant.They can;t just match the expected post-prepayment duration using linear products (which futures are), as you suggesting, since in that case they are going to be long or short duration at the current yield level. Makes sense?
Yes, makes perfect sense, thank you for the explanation. What about this huge put trade, against cash?
I thought most mortgage hedging was in the swaps market where you can create a infinite amount of supply at a price point (since the whole thing is a 'virtual' cash settled futures contract instead of physical settlement in treasuries). Why use treasury options with the attendant basis risk? Is vol cheaper in treasuries vs swaptions?
Gamma is a bit cheaper on the board There are advantages and disadvantages to both, it's too complex to get into at the moment.