The correlation between credit-default swaps and out-of-the-money equity puts has started to decouple over the past three months and derivatives houses, including Goldman Sachs and JPMorgan, have begun pitching trades to investors to take advantage of this market change. Several convertible arbitrage hedge funds, such as one of KBC Alternative Investment Management's funds, have started using out-of-the-money equity puts as a less expensive alternative to credit-default swaps when hedging the credit risk in convertible bonds (DW, 1/5).
The cost of using equity puts has risen relative to default swaps because of two factors, analysts said. The first is that implied volatility has risen in the equity derivatives markets as insurance companies and pension funds have started using equity options to hedge their exposure. The second is that a supply of synthetic collateralized debt obligations in Europe has been compressing credit spreads. Analysts said there may be some fundamental reasons that spreads are compressing, such as corporates reducing their debt.
"With equity implied vol at this level, credit default swaps look cheap," said Aldous Birchall, research analyst in quantitative relative value research at JPMorgan in London. "There is a play to be made and we are marketing these trades," he said, adding that convertible arbitrage funds and hedge funds that focus on credit and equity are looking at these strategies. Altaf Kassam, associate in European equity derivatives and trading research at Goldman in London, is recommending investors sell six-month out-of-the-money puts on Unilever NV. This is because the firm has a bullish outlook on the equity price, and the equity has a particularly high skew--meaning the price of an out-of-the-money option is high relative to the price of an at-the-money option. This means downside protection using puts is expensive, he explained.
