A creative solution to a problem that doesn't exist

Friday, April 27, 2007

Macro Man’s email box has been polluted on several occasions recently with solicitations for and explanations of a range of “exciting new financial derivative products.” Specifically, investment banks are sending out an increasing amount of drivel about things called CCOs and CFXOs: collateralized commodity obligations and collateralized foreign exchange obligations. If ever there was a solution for a problem that didn’t exist, this crap is it.

To quote a recent solicitation: “while this is a modification of CDS translated into FX space, we can see that this actually closely resembles a well-defined FX product, namely a one-touch option.”

In other words, there is already a liquid and easy-to-understand product where the market and credit risks are transparent. These banks wish to replace this product with an illiquid, opaque structure where the market risk is similar but the credit risk is an additional variable. This begs the question of why end users do not simply replicate the payout profile of this junk by combining traditional one touch options with conventional credit default swaps.

Macro Man has generally pooh-poohed those worry warts who view derivatives as the paving stones on the road to Financial Armageddon, but this rubbish certainly gives him pause for thought. A word of warning to anyone considering buying this junk: in all likelihood, the people who structure this stuff get paid more than you. Before buying, ask yourself where that money comes from!

Posted by Macro Man at 9:56 AM  


Well... depending on what product they are pitching. if its wedding cake stack of double no touches (or one touches) then there is no credit risk there per say. its just tranching cash flows. on the other hand, if they pitch real hybrids then the payout is joint between market and credit risks. hence you will be punting on certain correlations. not FX/FX but say FX/bond_z etc. credit/market(ie Equity/IR/Cmdty/FX) correlations are trading more and more. things like CCDS etc.

Anonymous said...
12:55 PM  

It looks to me like they are replicating the payoff profile of a CDO with the sale of foreign exchange and commodity one touches, such that those struck closest represent the equity tranche, the next closest the mezz tranche,etc.

It seems as if the product is for credit people that want to punt foreign exchange and commodities, or FX and commodity people who are too thick to structure the trade themselves.

There is an implicit bet on correlation within FX and/or commodities, but again- surely that is more properly addressed via correlation swaps or basket options.

Macro Man said...
1:07 PM  

yep. difficulty is having appropriate format for your investor. if guys wants a one touch option, but can not buy derivative.... he will ask to have principal guaranteed note structured so that coupon is linked to one touch. having tranches allows to partition leverage but keeping certain principal protection. then you get these babies rated...and here you go all pension funds selling FX vols at these levels...

Anonymous said...
4:00 PM  

But this is my point...anyone who would want sell FX vol can surely find a better way of doing it than through this sort of junk. This structure look's like someone's M.A. thesis project.

Meanwhile, the FX market proves itself to be an absolute joke as the dollar screams higher on nothing...

Macro Man said...
4:15 PM  

meaning.... someone T/P ? or someone hit the bid from the magic land ?

Anonymous said...
4:41 PM  

Well, already heard the stories that it's

a) down to the arrest of some al-Qaeda geezer, and

b) one of the oldest, largest, and best known CTAs has blown up after having an absolute shocker the last few years, thereby leading to a forced liquidation of positions.

Freaky Friday indeed!

Macro Man said...
4:53 PM  

Aren't you missing a couple of things here though, when comparing this against doing a basket of one-touches directly? 1) CFXOs are rated products, so whereas many investors that are constrained to buy only rated products can't trade FX as an asset class, they can buy CFXOs; 2) as these are tranched out, you can trade the view on FX correlation in the same way one would in tranched CDOs, so you're able to take a view on overall FX correlation rather than just, say, EUR/USD versus USD/JPY

Anonymous said...
11:29 AM  

The vast majority of fixed income investors can trade FX...at least those with multicurrency mandates. Even if one takes it as a given that one cannot trade OTC options such as one touches, it is certainly possible to bundle the underlying options into structured notes. The same holds true with correlation swaps.

I'd also ask how likely it is that someone who cannot trade FX using more conventional instruments will understand exactly what the hell they are doing when trading stuff like CFXO's (other than clipping coupons, of course.)

Macro Man said...
12:18 PM  

"It is certainly possible to bundle the underlying options into structured notes". How is this different to a CFXO...? For correlation swaps, how easy is it to trade correlation in equity versus mezzanine, versus senior, etc. across a basket without a CFXO? Also, many managers can trade FX, but only as an overlay to their portfolio - they can't trade it as easily as an asset by itself.

Anonymous said...
5:03 PM  

"How is this different to a CXFO?" That's my point. It isn't, really, in terms of market exposure. So why do we need CXFOs? At least structured notes are generally listed and priced on a igh frequency basis, so they can be marked to market. If one of the selling points of CXFOs is that you don't need to mark to market, and can thus hide turds in a portfolio...well, colour me unimpressed.

Also bear in mind that an overlay can be turned into an absolute return, FX as an asset class strategy by either a UCITS 3 type structure or by simply allowing cross-hedging....

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7:35 PM  

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