Wednesday, September 19, 2012

flow-vol franchise lowers cost of a structured vol provider

A strong flow vol business Drastically reduces hedging cost of a structured vol deal maker.

A structured vol trader in a sell-side basically constructs structured deals for hedge fund, mutual fund, insurer and other institutional clients. Typically based on client request, but the sell side could presumably market a given instrument to a client on an unsolicited basis too. As a sell-side, this trader always, always need to hedge her exposure. Being a structured vol trader, the biggest exposure isn't rates or credit but vol. The way to hedge away vol exposure is to enter into positions in options or var swaps -- using Flow volatility instruments.

Since the vol exposure in a structured deal can be large in dollar terms, the hedge involves large flow vol trades. These trades tend to entail sizable amount of transaction cost, which is factored into the quote to client. The lower this hedging cost, the more competitive is our quote.

Best way to lower the hedging cost is a strong flow vol business. In the same way, a strong cash equity business reduces hedging cost of an equity volatility trader and makes his bid/ask more competitive.

For a commercial bank, it's relatively easy to become a structured vol solution-provider. It's harder to build flow vol business, the traditional strength of investment banks (and broker/dealers?).

In the retail space, there are parallels. Target sells lots of shoes and pays lots of rent, so it wants to make shoes and also buy (rather than rent) commercial property so as to drive down cost and offer more competitive prices to consumers.

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