Investors have had plenty to keep up with over the past year – the collapse of Lehman Brothers in September 2008, the ensuing meltdown in financial markets and the later recovery in the equity sector. But research departments have had the even more difficult task of foreseeing the future. Users of JP Morgan’s research agree the bank has managed this task well. Those contacted by Risk picked out the bank’s macro-economic analysis, its relative-value trade ideas, and the breadth of its coverage for particular praise. However, the turbulence of the financial markets in 2009 has meant the bank has occasionally found its own economic forecasts out of step with its customers’ beliefs. JP Morgan’s own forecast is for a weak recovery with continuing high unemployment, and as a result the research team believes inflation will be benign. Many of JP Morgan’s clients, however, feel quantitative easing in the US and UK will lead to an uptick in inflation in the medium term. As such, the bank has needed to publish research on inflation hedging strategies. “We often need to recommend trades that fit clients’ views, even if we don’t share them,” says Pavan Wadhwa, European head of rates strategy at JP Morgan in London. For instance, the bank published research in September looking at option strategies for those anticipating higher inflation and interest rates in the UK. The bank evaluated payer swaption performance under numerous interest rate and inflation scenarios, and recommended customers extend the expiry of their options, target low strikes and sell the skew. It also found payer spreads perform better than outright payers, as investors can fund their positions by selling more expensive higher strike swaptions. The bank recommended buying 10-year 10-year at-the-money payer swaptions or at-the-money plus 100 basis points, and selling at-the-money plus 200bp or 300bp payer swaptions. By doing so, not only did customers benefit from the then high level of skew, but they also limited vega risk. Meanwhile, the bank’s analysts recommended a shift back into emerging markets in March 2009 – something Will Oswald, head of emerging market quant strategy, points to as one of the highlights of the year. Having shifted from underweight to neutral at the end of March, the bank then shifted from neutral to overweight in April. “That move from underweight was just three days after the year’s low,” says Oswald. Calling for a reinvestment in emerging markets was therefore unpopular at the time, he recalls: “There was very strong opposition from clients on that view, but we maintained it and it is now very highly rated.” March also saw the team publish research on the basis trade. The aim was to clearly articulate the risks of the trade, which looks to take advantage of the basis between bonds and credit default swaps (CDSs), and how best to evaluate and monitor the opportunities. “We put out a piece in March with a lot of detail on the trade – the risks involved, how to measure them, the expected cashflows going forward, how to measure basis and how to track it. You need to think about the dynamics of the trade, the value of the bond, interest rate sensitivity, the value of the coupon, the timing of default and so on. We also made a bunch of recommendations, which performed as expected,” says Saul Doctor, head of European credit derivatives research at JP Morgan in London. Since then, the basis between bonds and CDSs has narrowed, which Doctor says has led some investors to focus on more leveraged basis trades: “There’s the cost of funding the position, and as borrowing costs may be different for banks and hedge funds, that will affect how much leverage you can get. There are still some opportunities in US and sterling bonds, but people are looking at much more high-octane trades involving high-yield or subordinated financial bonds where there is no perfect hedge – the free money has mostly gone.” The research team has also devoted much of its time to educational efforts. In particular, it published research on the restructuring of Paris-based media firm Thomson in July, and the effect this would have on the CDS market. The restructuring was the first real test of the International Swaps and Derivatives Association’s small bang protocol, designed to allow cash settlement of CDS trades and facilitate the move towards central clearing (Risk December 2009, pages 62–64). Unlike the other credit events – bankruptcy and failure to pay – buyers and sellers of protection have the option to trigger the contract, causing huge confusion among market participants as to what course of action to take. “After the first Thomson restructuring, our research was very popular. We discussed the economic value of triggering or not triggering for CDS holders. I think people had tended not to look at that before, but it suddenly became relevant and they needed to understand it – people knew the trigger was optional, but they hadn’t thought about how they would make that decision,” says Doctor....
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