A host of major firms, including Goldman Sachs and Morgan Stanley, are reportedly sitting on substantial unrealized losses in their equity derivatives books as a result of dwindling implied volatility. Equity desks have been entering collars with customers since last year in which the banks are long calls and short puts, according to traders. Firms that did not hedge their positions are sitting on mark-to-market losses as a result of time decay. Players that have hedged their positions by selling futures are holding an increasingly asymmetrical hedge as the value of their option position diminishes. One head of equity derivatives said risk managers will start to force traders to close out the positions and realize the losses in the next three months if the situation persists. Officials at Goldman and Morgan Stanley did not return calls.
Implied vol has been plummeting since the fall. For example Dow Jones Euro STOXX 50 three-month vol was 38% in September, fell to 23% by January and is now 21%. Equity professionals said this is a global phenomenon with one-month vol on the Standard & Poor's 500 falling to 16.4% last week whereas it is typically above 20%.
Goldman's first quarter net revenues in equities were USD105 million compared to USD1.18 billion for the first quarter of 2001. This was partly due to "reduced market volatility and customer flow in equity derivatives," according to the firm's first quarter earnings statement. Morgan Stanley reported equity sales and trading net revenues of USD931 million, which is down 38% from a year ago. The firm's quarterly earnings statement attributes this to reduced trading activity, lower levels of market volatility and a decline in primary issuance.
The combination of reduced vol, customer flow drying up since Enron's collapse and hedge funds sitting on the sidelines spells trouble for equity derivatives desks, said traders. In particular, equity sales staff could find themselves in the firing line, especially the larger departments. Two market professionals singled out JPMorgan because of the bulging sales staff the firm has as a result of its merger with Chase Manhattan. Officials at JPMorgan said there will not be significant redundancies.
