The first variance swap on a credit-default swap index has been traded by Credit Suisse and Solent Capital Partners, a London hedge fund. Like an equity variance swap, the trade allows Solent to take a view on the direction of the credit index's volatility. The strike, maturity, pricing details and precise reference entity of the swap were not confirmed by either party.
Benjamin Leung, director in structured credit trading at Credit Suisse in London, and Chris Rayner-Cook, trader at Solent Capital, declined to say which way round the parties are in the trade. Market officials speculated Solent Capital is buying iTraxx variance, most likely on the Crossover index which references leveraged names and is linked to dips in equity volatility.
Solent Capital already trades equity variance swaps, which could also explain why it beat rival credit funds to the deal. A straw poll of London hedge funds by DW suggested equity and volatility arbitrage funds find the trade more appealing than straight credit funds. While credit options are growing in popularity (DW, 10/27), funds and dealers tend to use them for directional plays rather than to take views on volatility itself, as equity or fx fund managers can. The lack of liquidity for credit options--the longest maturity instrument is usually about nine months--also hinders hedging of more exotic credit instruments, such as variance swaps and explains why they have not been traded before.
Both Credit Suisse and Solent Capital declined comment on whether they had hedged the position, but trading officials said they had not seen any evidence of this and suggested the trade was likely executed in a small size with both parties comfortable carrying the exposure on their books. Whereas equity index options can be exchange traded and there are tradable prices throughout the day, the CDS indexes are fixed once a day and counterparties to a credit variance swap would have to agree on a daily closing level. Solent Capital and Credit Suisse said there is a mechanism in their swap to get around this, declining to give details.
Leung said the evolution of equity variance swaps, which first traded about five years ago and are now liquid on both equity indices and some single stocks, could be an indication of where the credit var swap will go. "I think we are seeing more convergence between the equity and credit world," he added. Credit option traders said it is an instrument hedge fund clients are interested in. "It will take off," agreed one rival.
