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An interdealer broker reinvents itself as a relative-value idea shop.

By J.C. Louis

As the fixed-income derivatives markets become increasingly commoditized, a lot of proprietary traders have begun to scan the world markets for new trading ideas.

Tullettt & Tokyo, the over-the-counter interdealer broker, has set up a special relative-value group to help do so. The group’s primary service is monitoring a whole range of assets in search of relative-value trades for presentation to the proprietary trading desks at the major money-center banks.

The rationale for an in-house boutique to service the banks is simple, says Vinayek Singh, director of capital markets at Tullettt & Tokyo. The group focuses on OTC and listed products in which Tullettt & Tokyo enjoys a strong niche—swaps, swaptions, caps, floors, options on Treasury or eurodollar futures, as well as spot or cash instruments and forward rate agreements. “Because we already broker these products, we can capture highly efficient pricing,” says vice president Aymen Samawi. “Knowing the best price of any given security or structure allows us to capture the greatest relative value of the market at any given time.”

Tullettt argues that there are a couple of good reasons why interdealer brokers might have an edge over their competition in the idea-generation business. “We have neither an inventory nor a trading bias,” says vice president Frank Filice, who adds that many trading desks do not have access to as wide a range of securities.

The team focuses on relative-value or volatility arbitrage trades for fixed-income assets of the United States, Germany, Japan and other G-7 countries. These trades fall into two broad categories—arbitrage or parametric. “While there is no longer real arbitrage in its purest form, there are many instances of second- and third-order arbitrage, which involves assets that are highly correlated,” explains vice president Srikant Sharma. “The parametric trades are essentially the same trades, with the exception that they involve taking a specific view on a specific parameter of the trade and market.”

Using a large historical database, the team constantly tracks volatility levels in nearly every conceivable fixed-income asset. Over the last six to eight months, for example, the spread between the swap rate and Treasury yields has widened. This has been viewed as a strong macroeconomic indicator, and a source of a number of trades.

Another favorite area is volatility arbitrage. Tullettt & Tokyo’s desk keeps close tabs on OTC and exchange pricing of caps, floors and swaptions. When it spots a misalignment, it fashions it into a trade that involves buying or selling two highly correlated contracts. “There’s a lot of structural and execution risk involved,” says Sharma, who stresses the need to identify all the attendant risks and isolate and take a view on each of the risk parameters. “We point out the structure and value of the trade precisely, and use Tullettt’s big floor orientation to get good prices on every fixed-income or currency item in the package.”

Swaptions are a key component of these volatility arbitrages, because of their cross correlations and what they reflect about the underlying economy. The swap curve, for example, is usually a reflection of the underlying corporate credit spread, based on the A+ or AA corporate curve. If there is a shift in the historical pricing relationships of different product classes of comparable securities, the team identifies the aberration or anomaly and structures a trade that will monetize from the pricing realignment. “Because we are talking about two different yields, the idea can generally be expressed through volatility as a spread trade, especially when anomalous pricing is not fully appreciated by the market in another,” says Sharma.

For example, volatility in the OTC Treasury options market can often outpace or outperform the volatility of the swaption market. Although the two would ordinarily correlate closely, they can become misaligned. “The 20-year Treasury curve implies a 5.62 fixed rate, for instance,” he explains. “The swap curve trading at 50 basis points over would imply a rate of 6.12. Normally Treasury and swaption volatility should be strongly correlated. The difference between Treasury volatility of the 10-year note vs. the swaptions volatility on the 10-year swap should arbitrage out to imply the spread, in this case, of 50 basis points.”

“Five instruments might be efficiently priced relative to where the underlying is, but we can identify the relative value between them.”
Frank Filice
vice president,
Tullett & Tokyo

But uncertain structural factors that influence Treasury volatilities can cause one to outperform or underperform the other. The desk may see uncertainty in interest rates, in the corporate supply and demand picture as well as in what is being swapped from fixed to floating. Using the note as the underlying hedge, it might recommend trading the floating rate and getting fixed, or structuring other trades that capture that volatility misalignment.

“Suppose,” continues Schrecon, “we wanted to get into a positive swap spread position. If you buy the Treasury and pay the floating swap rate, you are long the spread at, say, 50 basis points. You could make or lose 5 basis points per annum. The trade has a symmetrical look. Instead of going long the swap spread, might there be a more efficient way to manifest the same view? We look at the volatility of what the Treasury option and swaption imply. If I can get in at 52, would I take the same spread if I could get in at 48 by synthesizing the position with options?”

The swap team can structure trades to accommodate an aggressive or defensive view, depending on the client’s position. The client may want to protect open positions that benefit if spreads move down. Or he may want to use this product in a defensive posture so that if spreads move out, the core portfolio does not get hurt.

Another common trade involves helping the proprietary trading desks at money-center banks buy and sell Treasury swaps, options and swaptions based on their volatility to the underlying instruments. “Five instruments might be efficiently priced relative to where the underlying is, but we can identify the relative value between them” says vice president Frank Filice. “If a customer wants to put a trade on at a certain level, we can monitor all components and execute it at the optimal level. We won’t do it unless the trade and its associated parameters are at levels the customer wants.”

The fee for this type of high-end service is the standard commission Tullett charges for trades. Exchange-listed components of the trade are executed by Tullettt and cleared through Spear, Leeds & Kellogg Futures. The understanding is that on client approval, Tullettt will give the name of the counterparty if the trade involves OTC derivatives. The group is also in the process of exploring several entities that would facilitate trade clearing for the purpose of preserving client anonymity.

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