From Harley Bassman now at Simplify Asset Management:
Except for grifters practicing insurance fraud, no one buys fire insurance in hopes of their house burning down. This is the corollary to the epilogue of my prior Commentary that noted that “buyers of life insurance do not win when they die”. If you are reading this Commentary, there is little doubt that you have purchased an insurance policy, likely multiple policies such as auto, home, personal property, and liability. (I will ignore life insurance; obviously.)These sorts of products offer the challenge of both quality (coverage and deductible) as well sizing (total payout). Today we will take a deeper dive into an interest rate insurance Strategy outlined in my recent Commentary “The Helicopter Defense”–May 13, 2021.
The Strategy
At inception, a purchase of $50of the Strategy would entail: Buying$25 of the T 0.75% April 30, 2026, US Treasury 5-year note @ 100and...Buying a seven-year (expiration) payer swaption (put option) on $800 of a 20yr swap (bond) at a price of $3.125% ($800 * 3.125% = $25) This option is functionally a seven-year put option on a thirty-year bond.The table below is a MODELED profile of how such a strategy could perform, contingent upon a few important assumptions(*), as rates vary. This is not a prediction, but rather a modeled pricing projection using a $50 initial price compared to the CME listed “US” futures contract....
....MUCH MORE
I don't see a hyperlink to the earlier missive so here's our link to Convexity Maven: "The Helicopter Defense"
And remember where he is coming from (intellectually):
Our boilerplate introduction to Mr. Bassman starts with his definition of convexity:
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change).
Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
...The Convexity Maven is nothing if not a professional. Here is part of his mini-bio at MacroVoices:
Harley S. Bassman
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty-six-year career at Merrill Lynch. In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions. In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities. Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS - Beneficial Interests in GNMA Servicing. Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992. As managing and hedging prepayment risk became a priority focus for the financial markets, Mr. Bassman created PRESERV, Merrill's trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights. Later, Mr. Bassman managed Merrill's initial venture into off-balance sheet mortgage trading.
In 1994, Mr. Bassman assumed responsibility for OTC bond options.
Within a year, Merrill was the leader in this product sector. A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index. Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.And so much more, all those cutesy Merrill acronyms can be blamed on him and his team.
From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.
Mr. Bassman became the manager of North American MBS and Structured Finance trading in 2001. During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self-contained Sub-Prime mortgage conduit. He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform....
