Structured Note Hedging

December 11, 2006

Benjamin Martens (212) 526-6566 bmartens@lehman.com

Over the past three years, there has been an enormous volume of structured note issuance, and the sizes involved may have at times been enough to move markets. We discuss the nature and hedging of two of the most popular structures that have large curve and volatility components: non-inversion notes and leveraged steepeners. NON-INVERSION NOTES (NINs) Characteristics and Sizes Non-inversion notes are structures in which an above-market coupon is paid, contingent on the curve remaining above some specific value (usually, but not always, 0 bp). The structures are typically 15yNC3m Bermudan callables, and approximately $20-$25 billion of these notes have been issued since the beginning of 2004 in cash and derivative form. Much of the original issuance was in 10s30s NINs (some of which has already been called), while much of the issuance over the past year has been of the 2s10s and 2s30s varieties. Dealer Hedging One short NINs is in a flattener position and long curve convexity, as the dealer owns a series of digital floors, based on daily accrual, on the curve struck at 0 bp (the strike). The curve gamma and vega profile resulting from the notes exposure is shown in Figure 1. This results in the approximate net steepener hedge profile shown in Figure 2. As Figure 2 shows, dealer hedging due to non-inversion notes dampens curve moves north of the strike and accelerates curve moves south of strike. It should also be noted that for pricing purposes, it is the convexity-adjusted forward curve that is most critical (see Figure 3). For this reason, the spot curve trading to 0 bp (such as occurred recently in 2s10s) carries little importance for pricing or for hedging, as long as the convexity-adjusted forward curve remains steep; it is literally a matter of just one coupon.
More on Curve Hedging

The dealers curve delta is hedged with spot and forward steepeners. We calculate that $10 billion 10s30s NIN issuance implies a steepener position of approximately $15 billion 30s of 10s30s steepeners (before accounting for the Bermudan callability feature). For the sum of all NINs issued, we calculate that the curve dv01 is about $1.0-$1.5 million per bp near the strikes (split between 2s10s, 2s30s, and 10s30s). The exact figure is unknown because an indeterminant percentage of NINs have already been called. As noted earlier, this curve delta-hedging exerts a dampening effect north of the strike, in that if the curve flattens, dealers respond by putting on more steepeners and vice-versa. The effect is potentially much more interesting once the market trades through the strike embedded within the notes and the dealer become short curve convexity (see Figure 1). Here curve inversion results in further flatteners being initiateda form of positive feedback cycle. However, we find it unlikely that hedging needs of $1.0-$1.5 million dv01 per bp would distort unless a large curve move occurred very quickly.
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Lehman Brothers | Structured Note Hedging

Figure 1. The Approximate Curve Convexity Profile Buried Within a 10s30s NIN
Net Gamma/Vega Position in 10s30s 1.0 0.8 0.6 0.4 0.2 0.0 -0.2 -0.4 -0.6 -0.8 -1.0 -50 The dealer gets rapidly short gamma in 10s30s as it falls through zero In reality, this tail is depressed further because note is callable

Figure 2. The Steepener Hedge Is Maximal When the Convexity-Adjusted Strike Reaches Zero
Total Steepener Hedge 1.2 1.0 0.8 0.6 Dealer puts on Flattener in Response to Flattening Dealer puts on Steepener in Response to Flattening

Gamma Vega

0.4 0.2 0.0 -40

-25

25

50

-20

10s30s Spot Slope (bp)

0 20 10s30s Spot Slope (bp)

40

Source: Lehman Brothers

Source: Lehman Brothers

Figure 3. The Approximate Curve Convexity Profile Buried Within a 10s30s NIN
bp 35 30 25 20 15 10 5 0 -5 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Dec-16 2s10s Spot and Forw ard Sw ap Curve 2s10s Conv-Adj Spot and Forw ard Sw ap

Figure 4. NIN Issuance Likely Drove the Richening of 30yr Vega in 2004-2005
40 35 30 25 20 15 10 5 0 Nov-96 5y10y-5y30y bpvol Spread NIN Peak Issuance

Nov-98

Nov-00

Nov-02

Nov-04

Nov-06

Source: LehmanLive

Source: LehmanLive

Volatility Hedging Realities

The issuance of non-inversion notes, as long as the market is steeper than the strikes, results in the dealer being long curve convexity (or alternatively, short correlation). As the proper hedgea digital curve flooris not liquid, the dealer has to approximate the position with short-tenor vs. longer tenors vega and gamma spreads; these spreads are difficult to manage because the exposure is curve dependent and even sensitive to the level of yields! (because the notes are callable). To hedge the correlation, the dealer must own long-tenor vega vs. shorter tenor vega as long as the market is steeper than the strike. In the case of 10s30s NINs, we calculate that $10 10s30s NIN issuance generates up to $50 million of vega demand for 30-year tails on the surface. 10s30s NIN issuance peaked in the 3Q04-2Q05 timeframe; this vega demand was surely associated with the compression of 30-year vega and 10-year vega shown in Figure 4.
December 11, 2006 2

Lehman Brothers | Structured Note Hedging

It is interesting to consider the vega profile shown in Figure 1 with this in mind. A key point to realize is that it is likely that dealers have put on a significant amount of vega spreads over the past few years, but this vega requirement is highly curve dependent: It would decay both as the curve steepens (because the underlying NIN becomes callable) and as the convexity-adjusted forward curve trades through zero (because of the nature of the underlying option). Hence it is our expectation that shorter-tenor vega vs. longer tenor vega spreads are near maximal flatness right now; a move to a steeper curve will cause a gradual unwind of such vega spreads as the notes become callable, while a move to an inverted curve will cause a rapid unwind of such spreads as dealers must actually reverse the position in such an environment. The twist of the volatility surface may behave like a long straddle position on the curve over the next year for this reason. A last note we would make is that because of the difficulties in managing curve- and ratedependent vega spreads, as discussed above, dealers may have left themselves moderately net short correlationmeaning that dealers benefit when the curve moves. This may be part of the reason that correlation is bid up to such an extent currently. Figure 5 shows a history of 1-year trailing 2s10s realized correlation, as well as the current level of implieds. One-year options on 2s10s straddles are offered around 32 bpvol, which is on the low end of what has been delivered historically. We mentioned in an earlier write-up that even contingent on beginning from a nearly flat curve, realized 2s10s curve volatility during the Bretton Woods I period averaged 60 bpvol. We think 2s10s curve options are cheap, and the reason for the opportunity may be the residual risk of non-inversion note issuance. LEVERAGED STEEPENERS Characteristics and Sizes Leveraged steepeners are notes in which one is paid a leveraged factor times the realized spread of a particular section of the curve, floored at zero. There is oftentimes an abovemarket upfront fixed coupon payment over a lockout period. Leveraged steepeners may have been introduced in response to dealers need to cover some of the short correlation exposure remaining from non-inversion notes. There has been about $3 billion issued since the beginning of 2004 (see Figure 6), but the leverage in some of these notes is large, so the notional size may not be the best guide to their potential impact. There are records of notes paying coupons equal to 50X the 10s30s spread in the public domain.
Figure 5. 1y Trailing Realized Correlation and Implied Correlation in 2s10s. Correlation is expensive relative to history.
100% 95% 90% 85% 80% 75% 70% Jul-88
Source: LehmanLive

Figure 6. NIN Issuance helped drive leveraged steepener issuance. Bear in mind that leverage is large in leverage steepeners.
Gross Issuance, $bn 3.5 3.0 2.5 2.0 NIN Issuance by Quarter Leveraged Steepener Issuance by Quarter

1yr Trailing 2s 10s Correlation Current Correlation Pricing of 1yr Options Jul-93 Jul-98 Jul-03

1.5 1.0 0.5 0.0 Q1'04

Source: mtn-i.com

Q3'04

Q1'05

Q3'05

Q1'06

Q3'06

December 11, 2006

Lehman Brothers | Structured Note Hedging

Hedging Leveraged Steepeners Relative to NINs, hedging of leveraged steepeners is relatively straightforward. One who is short a leveraged steepener is simply short a call option on the curve, struck at 0 bp, and is therefore always short curve convexity. The convexity profile is shown in Figure 7, and the net steepener hedge profile is shown in Figure 8. Most interestingly, the net effect of the two notes is subtractive, meaning that leveraged steepeners reduce any net actively hedged curve convexity that may exist in the market (see Figure 7). However, if the market trades through the strike, then the effects from the two types of notes are additive. We therefore think it likely that curve realized volatility will pick up quickly and significantly due to dealer hedging if ever the markets convexity-adjusted forward curve manages to invert. CONCLUSIONS/SUMMARY The net curve impact of non-inversion note and leveraged steepener hedging is unlikely to be large above the strikes, as the curve convexities resulting from the two types of notes partially cancel. In general, the net hedging requirements are unlikely to be large enough to matter too much unless the move comes quickly, and other factors (especially mortgageconvexity-related) are likely to be more important. To the extent there is limited impact from these notes on the broader market, we expect to see asymmetric behaviour around the point where the convexity-adjusted forward 2s10s curve inverts. At that point, the short curve convexities of NINs and leverage steepeners become additive, and dealer steepener unwinds, in response to flattening, may exacerbate the inversion move and increase curve realized volatility, rather than having the dampening effect that we are used to seeing. We think the relationship between curve slope and twist of the vega surface across vega spreads is interesting, and we expect long-tenor vega to cheapen slowly vs. short-tenor vega as the curve steepens and rapidly if the convexity-adjusted forward curve inverts. Related trading opportunities driven by this analysis: 1. 2. We think 2s10s curve options are cheap (perhaps an excess return opportunity). We think vega spreads bear watching once the curve begins to move.
Figure 8. The Steepener Hedge in Leveraged Steepeners is Monotonically Increasing
Total Steepener Hedge (Times Leverage Factor) 1.2 1.0 0.8 0.6 0.4 0.2 0.0 -30

Figure 7. The Approximate Curve Convexity Profile Buried within Leverage Steepeners
Net Gamma/Vega Position in 10s30s 1.5 1.2 0.9 0.6 0.3 0.0 -0.3 -0.6 -0.9 -1.2 -1.5 -50 NIN Correl Gamma Steep Correl Gamma Net Correl Gamma

-25

0 10s30s Spot Slope (bp)

25

50

-20

-10

10

20

30

10s30s Spot Slope (bp)

Source: Lehman Brothers

Source: Lehman Brothers

December 11, 2006

Analyst Certification The views expressed in this report accurately reflect the personal views of Benjamin Martens, the primary analyst responsible for this report, about the subject securities or issuers referred to herein, and no part of such analyst's compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed herein. Important Disclosures Lehman Brothers Inc. and/or an affiliate thereof (the "firm") regularly trades, generally deals as principal and generally provides liquidity (as market maker or otherwise) in the debt securities that are the subject of this research report (and related derivatives thereof). The firm's proprietary trading accounts may have either a long and / or short position in such securities and / or derivative instruments, which may pose a conflict with the interests of investing customers. Where permitted and subject to appropriate information barrier restrictions, the firm's fixed income research analysts regularly interact with its trading desk personnel to determine current prices of fixed income securities. The firm's fixed income research analyst(s) receive compensation based on various factors including, but not limited to, the quality of their work, the overall performance of the firm (including the profitability of the investment banking department), the profitability and revenues of the Fixed Income Division and the outstanding principal amount and trading value of, the profitability of, and the potential interest of the firms investing clients in research with respect to, the asset class covered by the analyst. Lehman Brothers generally does and seeks to do investment banking and other business with the companies discussed in its research reports. As a result, investors should be aware that the firm may have a conflict of interest. To the extent that any historical pricing information was obtained from Lehman Brothers trading desks, the firm makes no representation that it is accurate or complete. All levels, prices and spreads are historical and do not represent current market levels, prices or spreads, some or all of which may have changed since the publication of this document. Lehman Brothers' global policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. To obtain copies of fixed income research reports published by Lehman Brothers please contact Valerie Monchi (vmonchi@lehman.com; 212-526-3173) or clients may go to https://live.lehman.com/.

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