From Citizen Jensen at Across the Curve blog
January 6th, 2009 1:10 pm
I have heard an interesting story on the neutering of the long end of the market.
As the market began to rally money managers pension funds and insurance companies were selling out of the money payer swaptions (think of it as a put on the swap rate) and were using the money to finance receiver swaptions( think of it as a call on the swap rate). The strikes were out of the money in each instance.
The market stages its historic rally and all of those low strike options are now at the money or nearly at the money. The holders of those options say thank you to their Deity and book their profits. There is a groundswell of this paying which pushes yields higher.
Here is the cool part of the story. That action by end users then compelled those who were short volatility on 30 year swaps to pay also. The payers in question are the same hooples who drove yields down when the exotic structured notes they held on their books required hedging. These characters are now stuck with bad positions in the other direction and they have exacerbated the correction as they adjust their hedges.
They should have their licenses to trade revoked or suspended!
Most of the losers are Asian and European banks. It appears that the American house have escaped (relatively) unscathed.
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