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.