I grasp the basics of a put option. John C. Hull. Options, Futures, and Other Derivatives (2017 10 edn). pp 8-9.

A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.

Can someone please ELI5 the bolded quote below?

"The Basis Monster that Ate Wall Street" (PDF). DE Shaw & Co. March 2009. p 3 of 9.

Of course, the value and even the sign of the cash-synthetic basis vary over time. If obliged to guess prior to the present financial crisis, most market participants probably would have ventured that a basis position that was long the cash instrument actually would have outperformed (that is, the basis would have become more positive) in a crisis, as worried investors would be expected to buy protection in the form of CDS, thereby pushing credit spreads on CDS wider than those on the underlying cash bonds. A research report issued by Lehman Brothers in August 2005, for example, noted that "hedging demand amid increased market volatility kept CDS spreads wider relative to cash."' But events have unfolded very differently in this crisis While the long cash/short synthetic bases of a few issuers may have outperformed, that's not been the case for the majority of issuers during this now protracted financial crisis, and a decision to put on long cash/short derivative trades as a rough form of crisis insurance would not have worked out very well.

What's critical here is that the two risk factors most responsible for driving cash-synthetic basis—namely, the availability of financing and the positioning (long or short cash relative to synthetic) of levered players—are quite

p 4 of 9.

inconveniently also two of the least desirable risk factors for a levered investment vehicle like most hedge funds. Those factors' combined impact literally describes the terms of a classic common-investor liquidation crisis. By incurring heavy exposure to financing risk and the portfolios of other levered investors, a levered hedge fund is effectively selling a gigantic put option on its ability to finance its own positions. Moreover, this put option has characteristics that greatly increase the probability that the option will move in the money at the worst possible moment. If a levered investor suddenly finds itself facing heavy losses, it's not a stretch to suppose that, at the same time and for largely the same reasons, that investor's equity capital base is under pressure from redemptions, its financing position is weakening because of a credit crunch, and other similarly positioned investors are liquidating. Worse still, all of these phenomena tend to self-reinforce in pernicious ways. In such circumstances, it's imprudent to count on financing and trading counterparties to provide help because, as already noted, they're likely to be deleveraging at the same time.

  • $\begingroup$ It’s figurative language. A put option is defined relative to a price payoff. There is no price distribution for the “ability to finance positions.” It’s a cute way of writing “they run the risk of blowing up if things go wrong.” $\endgroup$ – Brian Romanchuk Mar 30 '20 at 12:45
  • $\begingroup$ @BrianRomanchuk Thanks. Yes, I know this is "figurative language". I'm just trying to understand the simile. $\endgroup$ – NNOX Apps Mar 30 '20 at 16:45
  • $\begingroup$ Just how ELI5 do you want it? Do you want an explanation of what a "put option" is, or just an explanation of how what they're doing shares characteristics with a put option? $\endgroup$ – Acccumulation Mar 30 '20 at 22:32
  • $\begingroup$ @Accumulation I fancy "an explanation of how what they're doing shares characteristics with a put option" please. I already know what a put option is. $\endgroup$ – NNOX Apps Mar 31 '20 at 2:44

This was a really good question, and a fascinating topic (one that was admittedly hard to wrap my head around). I found a great video on this topic here.

When people say you're selling a (cheap) put option, they generally imply you're taking a needlessly big risk for only marginal upside. For example: not having adequate cash in your portfolio is essentially selling a cheap put on your liquidity. You get the marginal gain of avoiding cash drag...but you get absolutely steam-rolled if you're hit by a margin call. Best case you enjoy extra 1% / year, worst case you get annihilated. Seems asymmetric, no? I think that's what they're implying.

So, in an ideal world, you take JUST the position of cash-synthetic basis mispricing. BUT, DE's point is you're taking that risk PLUS the risk of whether or not other leveraged hedge funds can finance their position. Ominously enough, you're likely part of that "leveraged hedge fund" group yourself. If a competitor loses their financing, they will have to liquidate their trade. If they liquidate, it makes the mispricing WORSE. As they liquidate (and your trade moves against you), you likely ALSO have to liquidate because your financing is also drying up. All of these things would happen at once, and would self-reinforce.

Put succinctly, you are taking two co-amplifying risks (financing options + basis mispricing) - but only really getting paid for one of them (basis mispricing).

Does that hopefully help?

Cash-Synthetic Mispricing

This is essentially when you can buy a bond yielding 3% / year, and then turn around & buy insurance on it for 2% / year. It is riskless arbitrage...and theoretically Capitalism should compete it away. The difference between my numbers above (the 2% and 3%) is the "Cash-Synthetic Basis" referenced in the DE Shaw article.

"Cash" is a misnomer that refers to the actual underlying bond. "Synthetic" means a CDS, or some sort of synthetic instrument.

  • $\begingroup$ Thanks! Welcome! I'll need to re-read this, as I still don't understand. E.g. what's "cash-synthetic basis mispricing"? $\endgroup$ – NNOX Apps Mar 31 '20 at 2:45
  • $\begingroup$ Can you please respond in, by editing, your answer? Comment chains are cumbersome to read. $\endgroup$ – NNOX Apps Mar 31 '20 at 2:46
  • $\begingroup$ @Greek-Area51Proposal Hey, did you watch the video I linked in my first paragraph? It's a pretty good video. I can add an extra paragraph about cash-synthetic mispricing, though. $\endgroup$ – Davis Clute Mar 31 '20 at 4:27

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