Derivatives houses are gearing up for the takeoff of second-generation options on tranches of synthetic collateralized debt obligations. Following options on single name credit-default swaps and CDS indices, and coupled with burgeoning demand for options on tranches (DW, 3/7/04), dealers are looking at more exotic instruments such as cancelable options and options on first-to-default baskets.
Greg Tell, director and head of North American credit options and exotics trading at Barclays Capital in New York, said it has already traded cancelable options on first-to-default baskets. He added, "[The firm] is looking to develop strategies to incorporate optionality into more tranche trades." Martin St. Pierre, managing director and global head of structured credit derivatives trading with Bear Stearns in London, explained most firms entering the tranche options market write callable tranches because they want to buy volatility.
Hao Wu, managing director in global structured products at monoline Radian Asset Assurance in New York, said it is considering this product. The firm would sell the counterparty the right to cancel the option and profit from charging a higher premium, he explained. Investors like options on tranches, which give the purchaser the right to buy or sell protection on a specific tranche, because they can express views on volatility, said Wu, whose firm has sold about a dozen vanilla options on single tranches. The product is also economical, he said, explaining when dealers can't offer a tranche at the right price, investors can buy an option at their desired strike and get paid for waiting.
Costas Katsileros, an associate director and CDS trader with ABN AMRO in London, added the market could potentially see forward-starting CDOs with embedded options on tranches. "The sky is the limit," he said. Radian is looking at entering forward-starting CDOs (DW, 3/4).
Tell noted derivatives houses, including Barclays, are still working to perfect their models for pricing and hedging these products. Traders agreed modeling issues are the biggest impediment to this market's growth. One official explained modeling options on tranches requires firms first price the single tranche and then the option on the tranche, requiring a good handle on both correlation and the volatility of correlation.
