Short-term volatility position, Financial Management

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(a) The position of an agency that sells a callable coupon bond. We supposed that coupon bond has a maturity of 3 years and is callable only at the second year.

(b) The market thinks that the short term volatility reduces as FED's plans become clearer. The long term volatilities may perhaps increase because mortgage players hedge as FED cuts interest rates.

(c) A straddle is a long call as well as long put at the same strike price. The swaption long straddle is a long position in the swaptions which are described above. Its cash flow is displayed below

Therefore the traders take a long straddle position on the long dated swaptions and short straddle position on the short dated swaptions.

(d) If expectations are realized all positions would be in the money.

Trader has supposed a short position on short term volatility and short term volatility is lower. When this position is stopped it would be in the money. The trader as well has assumed a long position on the long term volatility and the long term volatility is higher therefore this position is in the money as well. Consequently the positions can simply be unwound.

(e) The investor is able to make money only if long term volatility increases in the case of CSFB. Where like in the case of Lehman even if long term volatility doesn't increase or even it reduce earnings from short-term volatility position would offset the losses.


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