What the TF? The real source of IG9 mispricing.
Okay, I can’t listen to anything more about IG9 10 years being “mispriced” or “distorted” or manipulated. Maybe it is, but let’s look at the facts.
There are three distinct markets at work here, the CDX index market, the tranche market, and the single name CDS market.
The fact is that IG9 10 year is trading “very rich” to intrinsic values. This index has allegedly traded huge volumes. Is comparable to IG8 and IG10 10 year. It is similar to IG18 5yr. It has overlap with IG15 7 yr. There are lots of other big liquid indices with a fair degree of name overlap and similar maturities. Yet we aren’t talking about them? Why not?
We are talking about IG9 because the trade is related to tranches. The only remaining tranche market is IG9. If the goal was to just sell index outright and make it trade extremely rich, many other indices would have served that purpose. So it is IG9 specifically because of the tranches, but let’s look closer where the price discrepancy might be.
It seems like only IG9 is mispriced, yet off the off the run indices it is by far the most traded. So we should assume that thing that is actively traded is mispriced? To say that the index is “rich” you need to calculate the value of all the single names. Ever try to get a price on Dec 20th, 2017? It is not as easy as getting as straight 5 year price. Of all single name trading, what percent is to that date? Probably a very low percentage, and of that, almost all of the trading will be related to IG9 index arb.
What is the likelihood that the single names are mispriced and not the index? The bid/offer for that date is larger than 5 year. How many dealers bought protection from arbs? They are short that date. They don’t have to post prices to a live trading screen. They can quote it wherever they want and just fade when a client comes in to sell it to them. If the single names were traded on an exchange, we may quickly see that it is the single names that are “marked” based on “quotes” by dealers that are caught short and want to protect that mark. That is an issue that should be addressed. In this case, everyone is jumping on the bandwagon that the index is mispriced, yet no focus on how the single name “fair value” is actually determined, and how real that is?
What is the likelihood that the tranche market is mispriced and not the index? First and foremost there are two prices for the tranches, a “with delta” and a “without delta”. Correlation books will make to the “with delta” price. Often the two prices are similar, but sometimes they can deviate by significant amounts. That is potentially going on here. The value of the tranche is based on a model. One large seller is there potentially taking the risk no delta. The other side of the trade is running it through a model. Are they able to use the model to artificially support the price on the tranche? Clearly if they have taken the opposite side of the trade, they have every incentive to do that. If I had a model that let me short AAPL and buy MSFT and said that trade had no risk, does it make it right? No. The correlation books are more sophisticated, but what is the likelihood that the correlation model is broken, and they are paying way too much for the tranche, and that is what is driving “mispricing”.
There are lots of issues this alleged trade highlights. Regulators need to address all of them, even the ones that don’t come with the sexiest of headlines and may require some real thought and effort on the part of the regulators, but the financial system deserves that.
E-mail: tchir@tfmarketadvisors.com
Twitter: @TFMkts