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Derivatives

Short Covering Drives Index Spreads Tighter

Hedge funds and bank prop desks were racing to cover short positions by selling protection on the iTraxx Crossover index last week after stock markets recovered from the previous week's global sell-off.

Hedge funds and bank prop desks were racing to cover short positions by selling protection on the iTraxx Crossover index last week after stock markets recovered from the previous week's global sell-off. London traders said the one-way trading reversed dramatic index spread widening seen two weeks ago after a 9% drop in the Chinese stock market. Single-name credit-default swap spreads pulled in generically tighter last week on the short covering.

Indices are more liquid than underlying names, so traders said activity and spread movement were concentrated in the indices. The Crossover, which references sub-investment grade corporate credits, tightened to 205 basis points Thursday from a wide of 248 bps Monday. This was still well above an all-time low of 167 bps Feb. 22 but it reduced the basis with single-name CDS, which were virtually unchanged, to an average of five basis points Thursday from 15 bps Monday.

Traders said volumes were significantly lighter than the previous week, as many clients kept to the sidelines taking a wait-and-see approach. Volume figures varied, with one trader saying volumes were lighter than average and another reporting a higher-than-normal daily average of a yard--or EUR1 billion. That compares with a high volume of six yards in one day at the peak of the sell-off.

"When the market blows out, the first thing everyone grabs for is index protection," explained one City trader Thursday, referring to the global protection buying spree of the week earlier. "People got hedged and wedged on the index and now it's coming back and hitting them in the face."

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