Over the Counter Option
Repo financing rates are equally important in the trading of Over-the-Counter (OTC) bond options. In understanding why, it is important to remember that most options traders trade volatility as opposed to taking a view on rates. Consequently, if they take a position in an OTC option, they will look to hedge their delta (ie exposure to the market) by taking a position in the underlying bond according to the following matrix:
If dealer sells short underlying bond, he can either buy a call or sell a put
Structure: Long Call A
Currency View: Bullish. Use when the value of he underlying asset is expected to increase.
Strike Selection: Any long call strike will represent a bullish view of the underlying asset. For high leverage buy out-of-the-money strikes.
Payoff: Profit unlimited as value of the underlying asset increases. Loss limited to premium paid.
Volatility View: Bullish
Structure: Short Put A
Currency View: Bullish. Use when the value of the underlying asset is expected to remain stable or increase slightly.
Strike Selection: The more bullish the view of the underlying asset, the more the selected strike should be in-the-money.
Payoff: Profit limited to premium received. Loss unlimited as the value of the underlying asset decreases.
Volatility View: Bearish
If dealer goes long the underlying bond, dealer can either sell a call or buy a put
Structure: Short Call A
Currency View: Bearish. Use when the value of the underlying asset is expected to remain stable or decrease slightly.
Strike Selection: The more bearish the view of the underlying asset, the more the selected strike should be in-the-money.
Payoff: Profit limited to premium received. Loss unlimited as value of the underlying asset increases.
Volatility View: Bearish
Structure: Long Put A
Currency View: Bearish. Use when the value of the underlying asset is expected to decrease.
Strike Selection: Any long put strike will represent a bearish view of the underlying asset. For high leverage, buy out-of-the-money strikes.
Payoff: Profit unlimited as value of the underlying asset decreases. Loss limited to premium paid.
Volatility View: Bullish
The overall picture is more complex however. On any given bond, the OTC options trader will have a portfolio of put and call options with a variety of strike prices and expiry dates. What they must do is calculate the delta of the entire portfolio to determine the necessary delta hedge, and take the relevant long or short bond position accordingly.
Again, the cost of financing the hedge is crucial. Options trading close to the money will have a premium that is small in comparison to the size of the underlying bond position. Consequently, the cost of funding the hedge (whether long or short the bond) is crucial in determining the price of an option, particularly if the life of an option is more than three months. The most graphic illustration of the relationship between repo and OTC options is the Option Conversion Reversal trade, described earlier.
