SeekerBlog

You’ll need to read all of David Goldman’s post carefully — this is a very interesting arbitrage example:

Bank protection has gotten very pricy during the past month, despite the Geithner plan. The cost of insuring Citigroup’s 5-year senior debt has jumped from LIBOR +300 bps to LIBOR +600 bps between the end of January and the end of March, while Bank of America has jumped from +200 bps to +400 bps.

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As I said earlier, Citigroup is like Schroedinger’s Cat, in a superposed state of being dead and alive at the same time.

Citigroup Stock Price vs Credit Protection, Past 12 Months

A simple way to think about the implications of the hockey-stick diagram described by the equity-credit scatter graph above is how important volatility is. The volatility sensitivity of an option increases as it gets closer to the money. Credit default swaps are an option, and the extreme volatility of bank stocks makes options more valuable. Again, they will either go up a lot or go down a lot. Volatility reconciles widening credit spreads and higher stock prices.

[From Hedge fund arbitrage in bank stocks and credit protection (or: Schroedinger’s cat revisited)]

In his 1 April post David elaborates on the option logic that accounts for this equity/bond behavior.

Theory really does work. The trouble is that there isn’t much of it. Option theory is the one really cool contribution to finance that practitioners can apply daily. It makes sense of seeming anomalies in market performance that seem to have stumped some of the pros. My post yesterday on why hedge fund players buy bank stocks and buy credit protection could use a bit of elaboration.

The WSJ Market Beat blog called attention to the discrepancy between performance of bank stocks and bank bonds during the past month: stocks up, bonds down (spreads wider). A minor-league bank strategist is quoted to the effect that credit predicts and equity confirms, so that the poor performance of bank bonds presages another drop in bank equity. In other words, the fellow trading credit default swaps knows something that the fellow trading equities doesn’t know. Considering that at hedge funds these are almost always the same people, that suggests a theory of generalized multiple personality disorder in the marketplace, in which the two sides of the personality don’t talk to each other.

As I wrote yesterday before the WSJ item came out, this has nothing to do with differing market views. It is an elementary problem in option valuation. Stocks by definition are an option on the future cash flows of a company (Merton). In the absence of dividends, e.g., the present status of C and BAC, the stock is nothing but an option on possible future cash flows. If there is extreme uncertainty — the stocks could zero out but could also dectuple — they are worth MORE, not less. If C is trading at $1 a share, as it did at the bottom, an investor could lose $1, or gain $1.5 to $2 with a very small change in its prospects. The greater the volatillity, the greater the upside vs. the downside.

Not so in credit. The opposite applies. Greater volatility means a greater chance of zeroing out. Even at 70 cents on the dollar, a Citigroup bond has more downside than upside. Preferred shares, on the other hand, at 30 cents on the dollar had more upside than downside, and traded up. It’s all about options and the effect of volatility on valuations.

With bank spreads in the hundreds and bank stock prices in single digits, the option component of equity valuation is huge, and the default option embedded in bank bonds is close to the money. Both bank stocks and bank bonds have a very high sensitivity to volatility or vega in option-speak. The signs are opposite: at very low valuations bank stocks benefit from volatility and bank senior debt loses. And that is why bank stocks go up and bank bonds go down.