How's a levered hedge fund effectively selling a gigantic put option on its ability to finance its own positions?
This was a really good question, and a fascinating topic (one that was admittedly hard to wrap my head around). I found a great video on this topic here.
When people say you're selling a (cheap) put option, they generally imply you're taking a needlessly big risk for only marginal upside. For example: not having adequate cash in your portfolio is essentially selling a cheap put on your liquidity. You get the marginal gain of avoiding cash drag...but you get absolutely steam-rolled if you're hit by a margin call. Best case you enjoy extra 1% / year, worst case you get annihilated. Seems asymmetric, no? I think that's what they're implying.
So, in an ideal world, you take JUST the position of cash-synthetic basis mispricing. BUT, DE's point is you're taking that risk PLUS the risk of whether or not other leveraged hedge funds can finance their position. Ominously enough, you're likely part of that &quot;leveraged hedge fund&quot; group yourself. If a competitor loses their financing, they will have to liquidate their trade. If they liquidate, it makes the mispricing WORSE. As they liquidate (and your trade moves against you), you likely ALSO have to liquidate because your financing is also drying up. All of these things would happen at once, and would self-reinforce.
Put succinctly, you are taking two co-amplifying risks (financing options + basis mispricing) - but only really getting paid for one of them (basis mispricing).
Does that hopefully help?
Cash-Synthetic Mispricing
This is essentially when you can buy a bond yielding 3% / year, and then turn around &amp; buy insurance on it for 2% / year. It is riskless arbitrage...and theoretically Capitalism should compete it away. The difference between my numbers above (the 2% and 3%) is the &quot;Cash-Synthetic Basis&quot; referenced in the DE Shaw article.
&quot;Cash&quot; is a misnomer that refers to the actual underlying bond. &quot;Synthetic&quot; means a CDS, or some sort of synthetic instrument.