The Royal Bank of Scotland has started quoting prices on novel, loss-capped options which give holders a passport to trade in and out of a credit index or a single-name credit-default swap. For an upfront fee, investors buy a zero-strike call option on the value of a trading account and then go long or short an index or CDS up to a set notional as frequently as desired over a fixed period. Losses are limited to the value of the up-front fee.
RBS started developing the instruments last year to attract investors who have held off from entering the market because of downside risk, said Michael Hampden-Turner, strategist at the firm. One trader at a hedge fund said he had been pitched the options and is interested in buying, but will hold off until liquidity improves.
At present, the upfront fee for passport options is roughly 50% on top of the cost of a vanilla option on the same underlying. One dealer said the potential downside risk for the option seller is too difficult to offset effectively, making the play financially unworkable. Hampden-Turner agreed there are risks, but said detailed analysis on a case-by-case basis, combined with the potential for stimulating growth in credit options, make it worthwhile.
To date, a handful of passport options on the iTraxx Main and Crossover have been bought in sizes of USD10-20 million by hedge funds and small European banks. Traders said RBS is the only house actively quoting prices on Bloomberg, but other firms are providing prices on request. The names of these firms could not be determined by press time.
