Morgan Stanley and JPMorgan are separately preparing to offer derivatives referenced to their joint TRACX credit-default swap indices, which could revolutionize the market. Traders at major rivals said options on the index could lead to a new market in volatility trading in credit-default swaps.
Michael Pohly, managing director and head of credit derivatives trading at Morgan Stanley in New York, explained that the liquidity of TRACX enables a whole suite of products, including options, to be built upon it. There will also be demand for leveraged and tranched products referenced to the index, according to Guy America, managing director and head of European corporate credit trading at JPMorgan in London. This would allow investors to choose their risk/reward appetite in much the same way as in a synthetic CDO. For example the investor could take BBB exposure to the European credit index.
Credit derivative options will function differently to default swaps, which for many investors have the same purpose as insurance, noted one researcher. Options on default swaps are not new, but have thus far only really existed as a "glint in a quant's eye," he noted. At present, options can be volatile due to their dependency on a single credit, explained Pohly. By offering the options on the index the probability of outcomes will be more normally distributed and this will encourage the market to develop, he said.
Several trading possibilities will open up by introducing option trading, including credit delta hedging, said Pohly. At present there is not a universally traded liquid credit-default swap index, which makes it difficult to offer second generation products, such as credit locks, noted one researcher. Credit locks would function in a similar way to interest rate locks, by allowing issuers to lock in favorable spreads without actually issuing debt.
The largest challenge in setting up the options activity will be documentation issues, with Morgan Stanley needing to anticipate several possible scenarios, Pohly said. For example if one credit in TRACX goes bad, as may happen in the event of bankruptcy, it needs to be determined how this will affect the options.