Deutsche Bank and Merrill Lynch are considering making liquid markets for equity-default swaps alongside JPMorgan, which started marketing the instruments last year (DW, 6/2/03). The swaps have so far been traded by most banks on a one-off basis for hedge fund clients, but not in a liquid manner. An equity-default swap is a deep out-of-the-money put on a single stock.
Officials say capital structure arbitrage hedge funds in Europe are beginning to trade EDS in order to make relative value plays between the EDS and credit-default swaps (DW, 10/11). Credit analysts expect the capital expenditure of corporates to rise in the next 12 months and this could increase interest in relative value plays of this type.
One official at a U.S. house in London said its exotics trading desk is looking to start making markets in EDS in January. "We're not sure how profitable it is for the banks, however," he noted. The notional volumes traded by hedge funds are around EUR2-3 million (USD2.5-3.7 million), so it is not likely to be a big business, he explained. But, this is unlikely to put equity derivatives houses off marketing the options, said one trader, because hedge fund business is highly valued and desks are looking for products that could give them an edge with clients.
Banks are also wary of a one-way market in EDS because hedge funds are more interested in buying EDS. A solution to this could be to structure collateralized debt obligations referenced to EDS in which the bank purchases EDS from investors. JPMorgan has structured several such deals in Europe and Asia and last month CDC IXIS launched a public CDO in Europe which used EDS (DW, 8/27).