Five months ago a French quant pitched me his bank’s most exotic product. A short correlation play whose name was an antonym of discord. In essence, it was long liquidity. “Stock pickers will come to the fore in the second year of equity market growth. “Differentiation,” it was said, “will be rewarded.” At it’s peak, the structure had over €1bn of hedgie money.
The French quant’s French bank was not alone in propagating the “short correlation” meme. Everyone was at it. In its 2011 investment idea book, JP Morgan predicted the range for realised correlation would lie between 15-20% and proposed clients short it. From April to September correlation, as measured by the Citigroup realised correlation index, rose 400% from 22 to 103.
Our quant did offer a profound anecdote to compensate for what would have been career-endangering advice, painting a vivid picture of what easy money really looks like.He explained that he knew the market was liquid because at the other end of his desk were salesmen punting options on variance swaps. “High open interest in OVS is evidence of exotic market depth”, he opined.
OVS buoyancy is to liquidity what robins are to spring. When you see the former, the latter is coming. It follows that he who understands the OVS landscape understands a lead indicator of bank funding conditions because when exotic flow is drying up it spells trouble. A fair concept, I was reassured.
Unfortunately, data on the OVS market is not freely available. Thankfully, there are other pockets of the market - more accessible than dispersion basket straddles or OVS trades – that also give investors a sense of the landscape.
Both the index and the single-stock dividend markets have shown evidence of famine lately. Prices had been falling year-to-date as investors fretted over whether euro banks would receive Euro TARP.
Deutsche Bank added to the bearish noises, applying a “macro discount” to the whole European 2012 dividend complex. Such “macro discounting” is part and parcel of what made shorting correlation such a bad idea – babies are being thrown out with bathwater.
It’s not all bad news, mind you. Such broadbrush analysis created a pocket of value that has already yielded 67% for our maiden trade.
Last month we suggested buying into Nokia’s 2012 dividend future. Societe Generale’s Weekly Dividend Update showed that this contract had risen by two-thirds in the past month. This may be an aberration as Bloomberg data shows a move closer to a 30% appreciation in value. We further suggested that to hedge that bet, in the case that Nokia announces it is to scrap its dividend – one could buy a deep out of the money March put on Nokia’s underlying shares. We caveated the idea: “The bear market has made entry for the second leg rather tricky… Right now, Nokia volatility is high and rising.”
But now it has ebbed. Euro STOXX 50 implied volatility has halved from a peak of 59.8. Nokia implied volatility has fallen similarly. Though one wouldn’t require the second half of the trade were we to take profits here. However, now is not the time to sell. Liquidity is still poor and spreads are wide: SocGen is quoting bid at 0.11 and ask at 0.19. In the context of our starting point – this isn’t too bad. The quote was 0.06 – 0.12 a month ago. Still, we think patience is well served here.
The rise in value happened on zero news-flow. Consulting LexisNexis, shows this publication and this column as the only source of Nokia dividend discussion in the past month. Analysts have by-andlarge been quiet too. BarCap’s note on the Q3 earnings passed without mention of dividend assumptions, though EPS assumptions for Q4 have been upped. Taking all of this evidence leads us to one of three conclusions:
A) We moved the market by writing bullishly on a previously illiquid corner of the single-stock dividend space. Not only have prices risen, open interest has up a lot in the past four weeks in both 2012 and 2013 contracts.
B) The earnings beat on October 20 engendered bullishness across Nokia’s derivative complex and single-stocks were just another location for that bullishness to evidence itself. After all, if Nokia’s selling more handsets than it had anticipated, finance director Timo Ihamuotila has less reason to take a sledgehammer to 2012 DPS.
C) “Pull-to-par” has begun. As we all know, dividend futures are very seasonal contracts that have more in common with zero coupon bonds than equities. When we are approach announcement and payment dates discounted prices tend to rise and become rather stickier.
The answer probably lies with B and C much as my ego would like to believe it is A. Dividends as an asset class have appreciated since the Euro TARP leak. Using the Lyxor Dividends ETF, which holds five years of dividend futures, as a proxy – dividends are up 7% since October 20. It stands to reason the most oversold of them, Nokia 2012, would trade briskly.
Whatever the cause of the rise, it’s not really a position that can be exited at this juncture. Liquidity, or a lack thereof, doesn’t allow it. Neither does common sense – a cash-settled contract is worth waiting for and now that the shares have gained 30% those puts are a much cheaper hedge against unexpected twists and turns than they were a month ago. I’m wedded to this trade by circumstance, but in this instance it’s no bad thing to be effectively short liquidity.