How's a levered hedge fund effectively selling a gigantic put option on its ability to finance its own positions? I grasp the basics of a put option. John C. Hull. Options, Futures, and Other Derivatives (2017 10 edn).  pp 8-9.


  A put option gives the holder the right to sell the underlying asset by a certain date for a certain price.


Can someone please ELI5 the  bolded quote below? 

"The Basis Monster that Ate Wall Street" (PDF). DE Shaw &amp; Co. March 2009. p 3 of 9.


  Of course, the value and even the sign of the cash-synthetic 
  basis vary over time. If obliged to guess prior to the present 
  financial crisis, most market participants probably would have 
  ventured that a basis position that was long the cash 
  instrument actually would have outperformed (that is, the 
  basis would have become more positive) in a crisis, as 
  worried investors would be expected to buy protection in the 
  form of CDS, thereby pushing credit spreads on CDS wider 
  than those on the underlying cash bonds. A research report 
  issued by Lehman Brothers in August 2005, for example, 
  noted that "hedging demand amid increased market 
  volatility kept CDS spreads wider relative to cash."' But 
  events have unfolded very differently in this crisis While the 
  long cash/short synthetic bases of a few issuers may have 
  outperformed, that's not been the case for the majority of 
  issuers during this now protracted financial crisis, and a 
  decision to put on long cash/short derivative trades as a rough 
  form of crisis insurance would not have worked out very well. 
  
  What's critical here is that the two risk factors most 
  responsible for driving cash-synthetic basis—namely, the 
  availability of financing and the positioning (long or short 
  cash relative to synthetic) of levered players—are quite 


p 4 of 9.


  inconveniently also two of the least desirable risk factors for a 
  levered investment vehicle like most hedge funds. Those 
  factors' combined impact literally describes the terms of a 
  classic common-investor liquidation crisis. By incurring heavy 
  exposure to financing risk and the portfolios of other levered 
  investors, a levered hedge fund is effectively selling a gigantic 
  put option on its ability to finance its own positions. 
  Moreover, this put option has characteristics that greatly 
  increase the probability that the option will move in the 
  money at the worst possible moment. If a levered investor 
  suddenly finds itself facing heavy losses, it's not a stretch to 
  suppose that, at the same time and for largely the same 
  reasons, that investor's equity capital base is under pressure 
  from redemptions, its financing position is weakening 
  because of a credit crunch, and other similarly positioned 
  investors are liquidating. Worse still, all of these phenomena 
  tend to self-reinforce in pernicious ways. In such 
  circumstances, it's imprudent to count on financing and 
  trading counterparties to provide help because, as already 
  noted, they're likely to be deleveraging at the same time.
This was a really good question, and a fascinating topic (one that was admittedly hard to wrap my head around). I found a great video on this topic here.
When people say you're selling a (cheap) put option, they generally imply you're taking a needlessly big risk for only marginal upside. For example: not having adequate cash in your portfolio is essentially selling a cheap put on your liquidity. You get the marginal gain of avoiding cash drag...but you get absolutely steam-rolled if you're hit by a margin call. Best case you enjoy extra 1% / year, worst case you get annihilated. Seems asymmetric, no? I think that's what they're implying.
So, in an ideal world, you take JUST the position of cash-synthetic basis mispricing. BUT, DE's point is you're taking that risk PLUS the risk of whether or not other leveraged hedge funds can finance their position. Ominously enough, you're likely part of that &quot;leveraged hedge fund&quot; group yourself. If a competitor loses their financing, they will have to liquidate their trade. If they liquidate, it makes the mispricing WORSE. As they liquidate (and your trade moves against you), you likely ALSO have to liquidate because your financing is also drying up. All of these things would happen at once, and would self-reinforce.
Put succinctly, you are taking two co-amplifying risks (financing options + basis mispricing) - but only really getting paid for one of them (basis mispricing).
Does that hopefully help?
Cash-Synthetic Mispricing
This is essentially when you can buy a bond yielding 3% / year, and then turn around &amp; buy insurance on it for 2% / year. It is riskless arbitrage...and theoretically Capitalism should compete it away. The difference between my numbers above (the 2% and 3%) is the &quot;Cash-Synthetic Basis&quot; referenced in the DE Shaw article.
&quot;Cash&quot; is a misnomer that refers to the actual underlying bond. &quot;Synthetic&quot; means a CDS, or some sort of synthetic instrument.