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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: YanivBA who wrote (56345)	9/15/2006 5:38:22 PM
From: forceOfHabit	Read Replies (1) \| Respond to of 116555

yaniv, "If I understand correctly the implied volatility would be high if the put is far out of the money...As enterprise value comes near the value of the outstanding debt...the implied volatility goes down" Not exactly. (You might be accidentally correct because there is a vol skew, but that is a refinement, not the main point.) When I say "implied vol" is high, it means either i) implied vol is high relative to historical vol (and implicitly, expected future vol); or ii) implied vol (implied for the bond put by the bond price) is high relative to equity option market implied vol. Think about "implied vol" in the same way you would for equity options. It fluctuates, sometimes it is high (relative to either historical implied or historical realised), sometimes it is low. If you traded equity vol, you would try to buy low, sell high. You would hedge against moves in the stock price using the stock. Its exactly the same for the bond put. You sell the put (by buying the bond) when the implied vol is high. You buy the put (by shorting the bond) when the implied vol is low. In the first case you hedge by shorting the stock, in the second by going long the stock. "Where did you learn this stuff?" I used to be a hedge fund quant before I started trading my own money. "That would suggest this strategy would be well complemented by buying a CDS contract insuring from default." In theory, default swaps trade just like the bonds. So to a hedge fund, they provide a convenient way to synthetically short the bonds (borrowing bonds is not quite as easy as borrowing stock), or way to go long the bonds without tying up so much capital. They definitely have a role to play in all this. "Whether the CDS is cheap because of counter party risk is another matter." A very interesting question. I'm not sure if anyone knows the answer. foh