What drives the spread between implied rate in options market and treasuries

Matt_ORATS

Matt_ORATS

Sponsor
Do you have thoughts on why the spread between the implied rates from the options market (calculated by ORATS) and the same maturity treasuries?

The purple line at the bottom is the spread or difference.
The blue line is SPY.
The green line is the implied rate in the options market at 1 year maturity.
The red line is 1 year treasuries, and the dark blue is fed funds.

0b757f21f39bf784cbbe0623b6a3d7c1.png

https://gyazo.com/0b757f21f39bf784cbbe0623b6a3d7c1
 
gpt

The spread between the implied rates from the options market (calculated by ORATS) and the same-maturity Treasuries, represented by the purple line in your description, can tell us a lot about the relationship between market expectations for interest rates, investor demand for risk-free assets, and sentiment around risk in the broader market.

Here are some thoughts on why this spread exists and how it can vary over time:

1. Risk Premium and Uncertainty in the Equity Market:
  • The implied rate in the options market (green line) reflects not only expectations of future interest rates but also the risk premium that investors demand for holding risky assets like stocks. When the implied rate in the options market is higher than Treasury yields (red line), it could indicate that investors are demanding more compensation for taking on risk, which widens the spread.
  • This premium may increase when there is uncertainty or volatility in the stock market, as options prices often rise (implied volatility increases) when investors hedge or speculate on market downturns. When SPY (the blue line) becomes more volatile or declines, implied rates in options tend to rise, widening the spread.
2. Fed Policy and Market Divergence:
  • The difference between the Fed funds rate (dark blue) and the implied rates or Treasury yields may also contribute to the spread. If the market expects the Fed to keep rates lower for longer, the spread between implied rates and Treasuries might narrow, as Treasuries respond more directly to the Fed’s guidance.
  • However, when there is a mismatch between market expectations and Fed policy, the spread may widen. For example, if the options market anticipates higher future interest rates due to inflationary concerns or economic strength, but the Fed maintains a more accommodative stance, the implied rates could rise faster than Treasuries, leading to a wider spread.
3. Liquidity Premium in Treasuries:
  • Treasuries, especially at short maturities like the 1-year Treasury (red line), are considered very liquid and virtually risk-free. During times of increased demand for safe-haven assets, investors may rush to buy Treasuries, driving their yields down.
  • This dynamic can cause the Treasury yield to fall relative to implied rates, widening the spread. The spread could shrink if demand for Treasuries normalizes or if the broader market feels more confident in risk assets.
4. Inflation Expectations and Economic Growth:
  • Inflation expectations play a critical role in determining the implied rates in the options market. If inflation is expected to rise, the implied rates will likely increase as the options market prices in the possibility of higher future rates to combat inflation.
  • On the other hand, Treasury yields are also sensitive to inflation expectations, but they may move more slowly if the Fed is seen as controlling inflation expectations well or if economic growth is perceived as weak. A divergence in these factors can drive a larger spread between implied rates and Treasury yields.
5. Hedging Demand in the Options Market:
  • The options market reflects not just expectations of future interest rates but also the demand for hedging. Increased demand for protective puts or other options strategies in the SPY may push up the implied rate, as more investors hedge against potential downside risks in the equity market.
  • When the demand for hedging rises, it increases the implied volatility and therefore the implied rates, causing the spread to widen compared to the relatively stable 1-year Treasury yields.
6. Supply and Demand Dynamics in Bonds:
  • Supply and demand in the Treasury market itself can influence the yields independently of economic factors. For instance, if there is a high level of demand for government debt (due to geopolitical events or economic concerns), this can push Treasury yields lower, widening the spread relative to the implied rates in the options market.
Summary of Key Factors:
  • Risk Premium: Implied rates can include a premium for equity risk, which Treasury yields lack.
  • Fed Policy vs. Market Expectations: Divergence between the Fed’s stance and market expectations can influence the spread.
  • Liquidity Premium: Treasuries' lower yields may reflect their status as a safe, liquid asset, especially in volatile times.
  • Inflation Expectations: Differences in how inflation expectations are priced into implied rates vs. Treasuries.
  • Hedging Demand: Increased demand for hedging in the options market can elevate implied rates, especially in times of uncertainty.
The spread can therefore be seen as a reflection of both macroeconomic factors and market sentiment, capturing the different ways in which the options market and the Treasury market incorporate risk, liquidity, and policy expectations into their pricing.
 
Thanks, Mark

Robert Morse told me "Larger Market Makers and Firm accounts that trade Reverse conversion are likely about FF+/- 25 to 35bps around FFs or better. If my firm book is mostly net long, I’ll use a rate to the higher end. If mostly short, the lower end."

Based on this, you'd expect implied rates to be right around the treasuries.

The 1 year implied rate is set by market makers (MM) based on supply and demand and their expectations of future interest rates, but so is the 1 year treasury.

I'd expect MMs to have large short stock positions, with most of their trades selling puts to hedgers and buying calls from overwriters. This leaves MM with short put long call and sold stock to hedge. This would have the effect of driving down implied rates as MMs look to neutralize this position and entice traders to sell puts and buy calls.

Options can be used by traders to borrow funds when the banks are not lending. This would tend to drive up implied rates.


MarkBrown said:
gpt

The spread between the implied rates from the options market (calculated by ORATS) and the same-maturity Treasuries, represented by the purple line in your description, can tell us a lot about the relationship between market expectations for interest rates, investor demand for risk-free assets, and sentiment around risk in the broader market.

Here are some thoughts on why this spread exists and how it can vary over time:

1. Risk Premium and Uncertainty in the Equity Market:
  • The implied rate in the options market (green line) reflects not only expectations of future interest rates but also the risk premium that investors demand for holding risky assets like stocks. When the implied rate in the options market is higher than Treasury yields (red line), it could indicate that investors are demanding more compensation for taking on risk, which widens the spread.
  • This premium may increase when there is uncertainty or volatility in the stock market, as options prices often rise (implied volatility increases) when investors hedge or speculate on market downturns. When SPY (the blue line) becomes more volatile or declines, implied rates in options tend to rise, widening the spread.
2. Fed Policy and Market Divergence:
  • The difference between the Fed funds rate (dark blue) and the implied rates or Treasury yields may also contribute to the spread. If the market expects the Fed to keep rates lower for longer, the spread between implied rates and Treasuries might narrow, as Treasuries respond more directly to the Fed’s guidance.
  • However, when there is a mismatch between market expectations and Fed policy, the spread may widen. For example, if the options market anticipates higher future interest rates due to inflationary concerns or economic strength, but the Fed maintains a more accommodative stance, the implied rates could rise faster than Treasuries, leading to a wider spread.
3. Liquidity Premium in Treasuries:
  • Treasuries, especially at short maturities like the 1-year Treasury (red line), are considered very liquid and virtually risk-free. During times of increased demand for safe-haven assets, investors may rush to buy Treasuries, driving their yields down.
  • This dynamic can cause the Treasury yield to fall relative to implied rates, widening the spread. The spread could shrink if demand for Treasuries normalizes or if the broader market feels more confident in risk assets.
4. Inflation Expectations and Economic Growth:
  • Inflation expectations play a critical role in determining the implied rates in the options market. If inflation is expected to rise, the implied rates will likely increase as the options market prices in the possibility of higher future rates to combat inflation.
  • On the other hand, Treasury yields are also sensitive to inflation expectations, but they may move more slowly if the Fed is seen as controlling inflation expectations well or if economic growth is perceived as weak. A divergence in these factors can drive a larger spread between implied rates and Treasury yields.
5. Hedging Demand in the Options Market:
  • The options market reflects not just expectations of future interest rates but also the demand for hedging. Increased demand for protective puts or other options strategies in the SPY may push up the implied rate, as more investors hedge against potential downside risks in the equity market.
  • When the demand for hedging rises, it increases the implied volatility and therefore the implied rates, causing the spread to widen compared to the relatively stable 1-year Treasury yields.
6. Supply and Demand Dynamics in Bonds:
  • Supply and demand in the Treasury market itself can influence the yields independently of economic factors. For instance, if there is a high level of demand for government debt (due to geopolitical events or economic concerns), this can push Treasury yields lower, widening the spread relative to the implied rates in the options market.
Summary of Key Factors:
  • Risk Premium: Implied rates can include a premium for equity risk, which Treasury yields lack.
  • Fed Policy vs. Market Expectations: Divergence between the Fed’s stance and market expectations can influence the spread.
  • Liquidity Premium: Treasuries' lower yields may reflect their status as a safe, liquid asset, especially in volatile times.
  • Inflation Expectations: Differences in how inflation expectations are priced into implied rates vs. Treasuries.
  • Hedging Demand: Increased demand for hedging in the options market can elevate implied rates, especially in times of uncertainty.
The spread can therefore be seen as a reflection of both macroeconomic factors and market sentiment, capturing the different ways in which the options market and the Treasury market incorporate risk, liquidity, and policy expectations into their pricing.
More...
 
My other comment was when you buy a 1 year T-bill, you lock in a discounted rate for that term. When you put on an option position with stock, your long/short rates can change, so when you price a conversion going out 1 year, you have to use what you expect not only what that blended rate will be, but also how dividends can change over that time. Also, today, the 1 year T-bill rate is about 4.07% while Fed Funds/Repos, which is a better reference rate for a broker's cost, right now is about 5.37%. I would not use T-bills for this.

Matt_ORATS said:
Thanks, Mark

Robert Morse told me "Larger Market Makers and Firm accounts that trade Reverse conversion are likely about FF+/- 25 to 35bps around FFs or better. If my firm book is mostly net long, I’ll use a rate to the higher end. If mostly short, the lower end."

Based on this, you'd expect implied rates to be right around the treasuries.

The 1 year implied rate is set by market makers (MM) based on supply and demand and their expectations of future interest rates, but so is the 1 year treasury.

I'd expect MMs to have large short stock positions, with most of their trades selling puts to hedgers and buying calls from overwriters. This leaves MM with short put long call and sold stock to hedge. This would have the effect of driving down implied rates as MMs look to neutralize this position and entice traders to sell puts and buy calls.

Options can be used by traders to borrow funds when the banks are not lending. This would tend to drive up implied rates.
More...
 
Mark, ORATS has an AI named Otto at orats.com. It is crazy that they can look at a chart and tease out implications. I use Otto to find out information on our own research!
This is what he said:
6cb6284462c8bb1dfb7c72be5001da8a.png

https://gyazo.com/6cb6284462c8bb1dfb7c72be5001da8a

The spread between implied rates from the options market and Treasury rates is indeed an interesting phenomenon. Let me share some thoughts on why this spread exists and what it might indicate:

1. Options Market Efficiency:
Our implied rates are calculated using put-call parity relationships in the options market. This spread could indicate some inefficiency or friction in the options market compared to the more liquid Treasury market.

2. Risk Premium:
The options market might be pricing in additional risk that's not reflected in Treasury rates. This could be related to perceived market volatility or uncertainty.

3. Supply and Demand Dynamics:
The options market has its own supply and demand dynamics that can differ from the broader interest rate market. For example, high demand for calls or puts can influence the implied rates.

4. Dividend Expectations:
Our calculations take into account dividend expectations. If these expectations differ from the market consensus, it could contribute to the spread.

5. Hard-to-Borrow Costs:
For stocks that are hard to borrow (for short selling), the implied rates can be affected. This is something we specifically account for in our calculations.

6. Liquidity Premium:
The options market might have a different liquidity profile than the Treasury market, leading to a liquidity premium being priced into the implied rates.

7. Market Sentiment:
The options market might be reflecting a different outlook on future interest rates or economic conditions compared to the Treasury market.

8. Arbitrage Limitations:
While arbitrage should theoretically close this gap, practical limitations (transaction costs, execution risk, etc.) might prevent perfect alignment.

9. Time Lag:
There could be some lag between changes in Treasury rates and their reflection in options prices, especially for less liquid options.

10. Calculation Methodology:
The specific methodology we use to calculate implied rates could contribute to some of the difference, although we strive for high accuracy.

It's interesting to note that the spread seems to widen during periods of market stress (when SPY drops sharply), which could indicate increased risk aversion or market dislocation during these times.

This spread could potentially be used as an indicator of market stress or inefficiency. Traders might look for opportunities when this spread becomes unusually large or small.
 
Duh. Options are funded at the prevailing funding rate across the dealer universe. Predictably, the cost of funding is higher than that of the US government.

You'll find that ES basis has very similar dynamics, so in the end it mostly boils down to balance sheet costs for the market makers.
 
  1. Isn't the 'prevailing funding rate' the Fed Funds rate?
  2. What if the dealers are short underlying? Wouldn't that drive the rate down below the US government if they collect FF for shorts at -25 and pay for longs at +35bps?
  3. Is 'balance sheet costs for the market makers' the net long or short underlying they have with their clearing firms?
-Slow learner
Slow Learning Elf said:
Duh. Options are funded at the prevailing funding rate across the dealer universe. Predictably, the cost of funding is higher than that of the US government.

You'll find that ES basis has very similar dynamics, so in the end it mostly boils down to balance sheet costs for the market makers.
More...
 
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