Interest in relative-value option plays has started crackling in the wake of an implied volatility spike in options on European iTraxx credit derivatives indices and a swoon on the comparable North American CDX indices. Hedge funds, bank loan desks and portfolio managers have started scrambling to find ways to play the volatility difference: on Wednesday, implied vol for December at-the-money forwards on the iTraxx HiVol traded at 39%, compared with 31% for the same trade on the CDX.HVOL.
The divergence was triggered when the two indices rolled into their sixth and seventh series. "The last two weeks were quiet in terms of flows because investors were concerned about a lack of liquidity in the off-the-run indices," explained Matt Mish, credit derivatives strategist at Barclays Capital in New York. "Series 7 has gotten rid of that concern."
Strong European demand for short-term downside credit protection drove up implied volatility on the new on-the-run iTraxx investment-grade and high-volatility indices. Meanwhile a lack of comparable U.S. demand drove down implied volatility on the CDX indices.
Analysts said demand for options on the iTraxx was stronger than on the CDX because there is a greater sense of directional certainty and risk aversion in Europe. "There is more bearish sentiment in Europe," said Lorenzo Isla, credit derivatives strategist at Barclays in London. "It's more balanced in the U.S.," he added. Mish said, "Absolute spreads in Europe are more compressed so investors are more inclined to buy downside protection. In the U.S., there is more indecisiveness and less client flow."
Mish and Isla said historical data suggest implied volatility levels are likely to reconverge, and recommended using the opportunity to put a cheap short on the CDX. They recommended selling three-month payer options on the iTraxx to fund the purchase of a three-month payer on the CDX. "It's a good way to sleep at night and limit your downside," one strategist said.
