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ABX Tranche Options Tipped As Next Big Thing

Options on standardized tranches of the ABX asset-backed securities index are seen as a likely new product by dealers.

Options on standardized tranches of the ABX asset-backed securities index are seen as a likely new product by dealers. Housing sector bad news is driving investors to look for more ways to position on housing-related credit. Buying options could prove popular as a way of getting exposure to ABS, with the added advantage that losses are restricted to the premium paid.

Options on corporate credit indices such as iTraxx and CDX have been slow to take off (DW, 10/10/05), due to lack of two-way demand and modeling issues.

The ABS market, however, is expected to have a better balance of demand for both payer and receiver options because the jury is still out on housing data. Dealers pointed to the fact that interest in credit-default swaps on ABS collateralized debt obligations is now split equally between buyers and sellers, since more hedge funds have entered into the market and are buying protection, balancing the selling by CDO issuers. Most firms have already received inquiries into writing options on the ABX, and Goldman Sachs and Deutsche Bank are already said to be involved in writing contracts on the full index. Officials at Goldman and Deutsche Bank declined comment.

Because demand for ABX tranche options is expected to outpace interest in corporate tranche options, this is expected to give dealers incentive to overcome modeling problems and establish more accurate pricing. Deutsche Bank, Barclays Capital, Lehman Brothers and JP Morgan are said to be the only firms structuring callable corporate credit tranches on request, and are expected to work to apply their models to the new ABS version. Officials at the firms declined comment.

Market participants noted that while it's still too early to tell, options could be an ideal tool for large CDO underwriting houses, such as Merrill Lynch, that will want to hedge or conversely take advantage of their approaching pipeline of deals. Although Merrill tried to make a big push with the corporate product last year, an official at the firm said it stopped doing the trades because of modeling issues.

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