Just because I disagree with the conventional wisdom that the US is too big to fail doesn’t mean I actually believe that’s a high probability.
Hedge or don’t hedge. Hedge a little or a lot. But if you want to hedge but have a “Heee-yal no!” response to the simplest hedging strategy suggests some inconsistency somewhere.
I’m looking for strategies that are only slightly costly in the likely event of an 11th hour deal, but highly beneficial in the unlikely event of a default.
Again, to the extent that you believe that the risk is a small chance of not paying out US treasury bonds then the obvious hedge is to short sell said asset. You want it to be only slightly costly, which places limits on how much hedging you can do via this (or any other) method. Since the market value of US treasury bonds cannot increase significantly without becoming mathematically absurd this is not a risky move.
You can likely optimise beyond this approach but if the strategy seems drastically aversive rather than potentially inefficient then something is broken.
I must admit, I don’t really understand bond pricing (which by itself probably means I’m not ready to be shorting them). I wouldn’t short a stock unless I was very confident it would go down, because if I’m wrong there is no theoretical limit on my losses, unlike being wrong about a long position. If a default is averted, there could be a market rally, and people shorting index ETFs would get screwed for example. Does it work differently for bonds?
I wouldn’t short a stock unless I was very confident it would go down, because if I’m wrong there is no theoretical limit on my losses, unlike being wrong about a long position.
Notice that the thing you need to be very confident about is that it will not go up dramatically. Having a high probability of staying stable or only raising by a small amount isn’t a problem.
Assume at some point you have reason to believe that you have information that the market does not and which creates a moderately small possibility of a stock dropping value dramatically. Also assume that you have a limited tolerance for risk. ie. You’re willing to invest $10k based on the expected value calculation but would accept no chance of losing more than that. In that case you can short sell the stock and also buy call options at a higher valuation (or just use a ‘stop order’). That way you gain when the price drops and lose when the price rises but the losses are limited to a predetermined maximum. You can then crudely visualise the payoffs as just similar to betting on a horse you think will win. You will probably lose a small predetermined amount but if the horse wins you win a lot.
There isn’t a difference in how shorting works. There is a difference in what bonds and stocks are. Stocks are based on the value of a company, which can obviously go through the roof. A bond is a promise to pay a fixed amount of money over a specified time. The monetary value of an IOU for $10 + $1 interest paid over a week is never going to be greater than $11 now, that’d be really weird. Bonds can lose all their value catastrophically if the issuer loses credibility but they can never gain value above “Bond with the specified terms assuming unquestioned reliability of issuer”.
...so there is a limited downside risk unlike shorting stocks?
And the upside is still (theoretically) the full price at the time you short it because it could in principle drop to zero if the debtor defaults? Is that correct?
Hedge or don’t hedge. Hedge a little or a lot. But if you want to hedge but have a “Heee-yal no!” response to the simplest hedging strategy suggests some inconsistency somewhere.
Again, to the extent that you believe that the risk is a small chance of not paying out US treasury bonds then the obvious hedge is to short sell said asset. You want it to be only slightly costly, which places limits on how much hedging you can do via this (or any other) method. Since the market value of US treasury bonds cannot increase significantly without becoming mathematically absurd this is not a risky move.
You can likely optimise beyond this approach but if the strategy seems drastically aversive rather than potentially inefficient then something is broken.
I must admit, I don’t really understand bond pricing (which by itself probably means I’m not ready to be shorting them). I wouldn’t short a stock unless I was very confident it would go down, because if I’m wrong there is no theoretical limit on my losses, unlike being wrong about a long position. If a default is averted, there could be a market rally, and people shorting index ETFs would get screwed for example. Does it work differently for bonds?
Notice that the thing you need to be very confident about is that it will not go up dramatically. Having a high probability of staying stable or only raising by a small amount isn’t a problem.
Assume at some point you have reason to believe that you have information that the market does not and which creates a moderately small possibility of a stock dropping value dramatically. Also assume that you have a limited tolerance for risk. ie. You’re willing to invest $10k based on the expected value calculation but would accept no chance of losing more than that. In that case you can short sell the stock and also buy call options at a higher valuation (or just use a ‘stop order’). That way you gain when the price drops and lose when the price rises but the losses are limited to a predetermined maximum. You can then crudely visualise the payoffs as just similar to betting on a horse you think will win. You will probably lose a small predetermined amount but if the horse wins you win a lot.
There isn’t a difference in how shorting works. There is a difference in what bonds and stocks are. Stocks are based on the value of a company, which can obviously go through the roof. A bond is a promise to pay a fixed amount of money over a specified time. The monetary value of an IOU for $10 + $1 interest paid over a week is never going to be greater than $11 now, that’d be really weird. Bonds can lose all their value catastrophically if the issuer loses credibility but they can never gain value above “Bond with the specified terms assuming unquestioned reliability of issuer”.
...so there is a limited downside risk unlike shorting stocks?
And the upside is still (theoretically) the full price at the time you short it because it could in principle drop to zero if the debtor defaults? Is that correct?
Correct on both counts.