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Minyan Mailbag: Heisenberg Uncertainty



Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Prof. Succo,

At the end of the second paragraph in your piece on Nightmare hedges, you talk about how the mortgage players can move the bond market with their hedges since they are such large players. This is effectively the Heisenberg Uncertainty Principle at work where one action can/does have an influence on the next.

So my question for you is how do we judge the amount of liquidity that is available in the bond market (AKA OTC Interest rate derivatives market)? In other words, how much (Dollar wise) can get done at one price before the price moves?

I would think that bond market liquidity would be changing all the time? But would it CHANGE (Decline) dramatically if foreigners take a step back from the U.S. bond market? Would such a decline in liquidity make implied volatilities rise in interest rate markets?

Your thoughts are much appreciated.

Minyan Mark

Mark -

When you shine a light on a sub-atomic particle, you change its momentum; but you need to shine a light on it to determine its direction. So you cannot know both a particle's momentum and direction at the same time. Sub-atomic particles are very queer: they pop in and out of existence and you cannot even really talk about them as "anywhere at anytime". They only exist in probability terms.

Quantum physics is so strange even Einstein could not accept it. But it has proven extremely valuable in describing reality as it truly is.

Anyway, liquidity in any market changes for various reasons. A helpful way to look at it is to call liquidity the antithesis of volatility: when liquidity is high, volatility is low; when volatility picks up, liquidity drops. Liquidity is there when you don't need it and not there when you do. This is why the most money is made by those participants who step in and provide liquidity when it dries up. Of course that can backfire.

When options are sold, it introduces gamma into the marketplace. One party is long gamma and one party is short it. The market balances out until one party overtakes the other for various reasons. One reason might be that one party is leveraged and one is not. If the levered party is short gamma and the market begins to move, they will react more violently because they cannot afford the loss.

In the case of the GSEs, they are short an immense amount of gamma as I described before. But who is long that gamma to balance them out? It essentially is the homeowner that is long the gamma: they are long an option to refinance. The act of refinancing expires the imbedded option that the GSE is short and the gamma then goes away.

The problem occurs when the model incorrectly interprets the amount of refinancing that will occur. If the model overestimates this amount, the GSE will eventually have to sell out the bonds that were bought.

In other words in this case the long gamma is very static: the re-hedging (refinancing) by homeowners is not gradual, but comes in lumps. It is hard for the GSE (their model) to be right because of so many extraneous factors. On top of that, what would you say if I told you that even normal options are not priced right, that the models we use are essentially irrelevant precisely because of what Scott wrote about stock distributions (they only do a good job of estimating option prices for moves around the mean and not the tails)?

Imagine what I think of the GSE models that are based only on tail events. I think the best that we can expect is that re-hedging costs for GSEs are consistently underestimated. This has been proved through experience.


Prof. Succo

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