Tuesday, 9 December 2008

Hedging procyclicality

It suddenly occurred to me this morning that you can, theoretically, hedge the cost of procyclicality.

Suppose your credit risk capital requirements in good times are EUR 10B, and they rise to EUR 13B in a crisis. This is roughly right for a large bank: a Deutsche bank study showed between 30 and 80% increases in capital for their investment grade corporate book, while the Bank of England found 15-40%.

The cost of equity capital is somewhere around 12% for a large bank. Let's go with 10%, assuming that you can meet some of it from cheaper Tier 2 capital. That means you need to make EUR 300M a year to be hedged. Hence you want some position that makes money in a recession. Considering the iTraxx, we see that a 150 b.p. credit spread change is perfectly possible: this has actually gone from 25 to over 200 in the recent events. Unfortunately to make 300M from a 150 b.p. change, you would need to buy a notional of 20B. That's quite a bit of iTraxx.

How about equity indices? Clearly the business cycle is quite long: five years peak to trough would be reasonable. So how about buying an ATM five year put on the S&P? Assuming a 20% fall from the high - it has gone down more recently, but 20% is more typical of an average recession - you would need a notional of EUR 1.5B. That's perfectly possible. But the premium for a five year ATM S&P put using pre-Crunch vols is very roughly 20% of notional, and you need to earn that premium back too. Hmmm. You can do better by buying away from the money, longer dated options and profiting from the move in implied vol too, but the notional will be even larger. Also if the recession lasts longer than a year, you need more puts.

So perhaps practically it is not so easy. But the *idea* of hedging increases in capital requirements is interesting...

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2 Comments:

Blogger Timothy said...

Presumably nobody else will have the same idea, otherwise chaos ensues as every bank tries the same trade; even if they don't in a concentrated system if you are buying hedges from people who are also procyclical then they are taking even more procyclical risk and at higher risk during a downturn, how do you hedge the c/p risk?

8:36 am  
Blogger David Murphy said...

Exactly. And the accounting doesn't work: you suffer mark to market volatility on the hedge, but under FAS 157/159 you can't record an offsetting change in your cost of equity. For this reason alone I doubt anyone would actually do it.

As a side note, in the mid 1990s I looked at hedging loan loss reserve changes by going long the TED spread. [This was before the iTraxx, which would have been a better hedge.] The idea was that the TED spread was elevated in low credit quality environments so one could put on a rough hedge against increases in loan loss reserves. The trade worked based on extensive back-testing. But it created too much earnings volatility, so it was never (so fas as I know) actually put on.

8:19 pm  

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