Credit was the last major traded asset class not to have a liquid option market. The credit derivative revolution of the 1990s provided a unifying vector of assuming credit risk by making various credit exposure fungible, but had provided a liquid way to transfer optional risk on the price of credit. This risk has already been in existence for years in the more traditional credit markets. Callable/Putable corporate bonds are popular in the U.S. and revolving credit facilities on the lending side involve some form of credit optionality. Callable asset swaps in the well-established stripped convertible market even provided the embryo of a market. But as for credit risk before the introduction of derivatives, the risk transfer mechanisms were lumpy and heterogeneous. Also, in most of those cases, the option is not always exercised economically; in the case of a revolving facility, relationship considerations typically come into account; for the stripped convertible market, the call also depends on the price of the underlying equity, since the conversion into equity would trigger the call. The development of a traded market is likely to rationalize exercise decisions, in line with a market driven allocation of credit.
The gap is now closing thanks to the development of options on credit-default swaps. These contracts have now been actively trading for about a year and volumes have picked up significantly since the beginning of the calendar year, with JPMorgan in London alone trading billions of dollars (notional) this year.
The spark that ignited the phenomenon came with the creation of CDS indexes, which naturally lead to the creation of macro risk management tools, such as standardized tranches of risk and options on those indexes. Index options are also easier to manage than their single name counterparts given the relative stability of the underlying. As with their equity derivative comparables, they are powerful tools in macro portfolio management because they allow investors to express more granular views.
Part of this explosive growth can be explained by the fact that it has borrowed documentation and techniques from other products, such as interest rate swaptions. The first default in the TRAC-X portfolio allowed the option documentation to be tested and it worked. Gaps are more likely in credit even though the depth of the market has improved tremendously in the past years. While this leads to specific issues in the modelling of credit, in particular revolving around the volatility smile, the pricing and risk management technology is largely dependant on the advances of interest rate modelling. The market in general is widely familiar with those techniques. The growth is likely to be fuelled by the development of innovative structures leveraging those new building blocks. Product innovation has now entered into a virtuous circle: new risk management tools can be used in the structuring of more complex trades, which in turn will feed the liquidity of the options. A particular area of interest lies in hybrid structures involving rates and credit, which we discuss at the end of this article as an illustration.
Trading Products Are Getting More Liquid
Options on CDS are traded in their simplest form: a European option that gives the holder the right to buy or sell protection on a specified reference entity for a specified future period of time, typically five years, for a certain spread. The option typically knocks out if the reference entity defaults during the life of the option.
A receiver is a call on risk and conversely, a payer is a put on risk. This risk terminology is typically used rather than making reference to an option on a spread or on protection because it allows a seamless view of credit optionality across all products.
As with equity derivatives, index options are attracting the lion's share of the liquidity and the imminent merger of the TRAC-X and iBoxx indices should improve that. Besides the ability to express complex views on the level of the index, including call spread and put spread strategies, those contracts make it possible to isolate credit spread volatility. In effect, this opens the possibility to isolate the volatility risk and trade credit volatility as an asset class.
The comparison with equity derivatives has its limits and credit indexes have run into limitations of their own. In particular, the liquidity based inclusion rule, which decides the composition of the index, means that there is a relatively high turn over every roll. This makes it challenging to offer long dated options on the index itself since its future composition is unknown.
On the single name front, an increasing number of players are getting involved, expressing more idiosyncratic and tailored views. We saw credit portfolios on both sides of the market. In their traditional role of hedging retained credit positions, they have been buying out-of-the-money puts on single names as a way to reduce hedging cost, also the more sophisticated players are hedging their counterparty exposure on their derivative portfolio, which typically have an asymmetrical exposure to spreads, via buying a put on the index. Credit portfolio mandates typically extend to diversifying the bank portfolio to credits, which do not appear naturally in their portfolio. In this investment exercise, and given historically tight spread levels, selling optionality through covered calls has helped achieve target levels. Proprietary trading desks have also made the most of these yield-enhancing
Hedge Funds
Hedge funds, the usual suspects for sophisticated risk management tools, are also becoming more active participants. Options typically allow them to express spread views in a more granular fashion. They are the more likely players to start arbitraging the implied and realized volatility, but there is no evidence that they have started doing this. Cancellable protection has also been used as an alternative to selling callable asset swaps as part of their traditional convertible arbitrage activity. As the credit markets are becoming more efficient and credit dedicated hedge funds are putting more sophisticated strategies in place, combination strategies involving tranches and options are likely to become increasingly popular.
Real Money Accounts
Real money accounts have also been joining the party. Insurance portfolio managers have been using options for macro portfolio management. Some have also tactically sold covered calls to enhance their return. Given where we stand in the credit cycle, these strategies are likely to get institutionalized: a systematic covered call strategy, which is rolled every few months, should outperform during a stable or bearish market. Those strategies are already commonplace in the equity markets. Selling the upside should also be natural to the credit market since it allows the investor to retain carry while pocketing some premium for giving up potential capital appreciation.
Correlation Desks
CDO shops' correlation desks are familiar with the risk and traditionally have large "natural" volatility and gamma positions. Although hedging their volatility in the option market probably does not represent a long-term solution to their position, they are likely to be looking at this tool as a way to help them warehouse the risk. As this market continues to gain in sophistication, options will find more applications within correlation structures: options on tranches and tranches on which the coupon resets based on the on-market credit spread are likely to be the next step.
'Merger' Of Fixed Income Markets Will Fuel Growth
The fixed income derivative market started with a single index (LIBOR), which was a proxy for the market participant's funding rate. As more credit curves become tradable, market participants are likely to shift part of their activity to either their investments (or their own) funding rate or a closer benchmark.
The vast majority of fixed income structured investments, however, are callable. The development of credit options means it is now possible to create investment profiles, which combine the enhanced return of credit and the benefit of selling optionality. The development of these techniques is likely to fuel further growth in the credit option market.
Range Accruals
For example, the most popular structured note is the range accrual, which pays a high coupon as long as LIBOR stays between a pre-determined range. They are typically callable on a multi-European basis. In order to get a credit risky structure, one solution would be to approach the company to have them issue a structured note (France Telecom just issued a sticky cap structure). In practice, it is often impractical to try to manage the funding need of a corporate at the same time as the risk appetite of an investor. The alternative would be to combine this complex interest rate coupon with collateral, bought in the secondary market, to create a compounded exposure between credit and interest rates. These so called dirty structures can be a problem when the interest rate call is exercised because the holder is left with collateral that may be trading substantially below par. Also, in the case of a default of the underlying credit, the investor would have to unwind the interest rate swap, which could lead to additional losses. It is now possible to overlay this structured coupon on top of credit collateral. The combined structure, that is the swap and the collateral, is then callable. This hybrid call has a credit aspect, since the optionality takes into account the price of the collateral.
To enhance their yield, investors traditionally had to choose between moving down the credit spectrum or taking further interest rate risk. They can now tailor how much risk they want to take on in each asset class and combine these in a single structure. These new structures could also have implications for the existing structured note market. European medium-term note investors, which represent the vast majority of structured note investors, are already taking the credit risk of the issuer. Instead of being compensated for this risk, they are often being charged, as arbitrage issuers use this market as a way to get cheap funding. With the development of hybrid risk management, they may find it harder to charge 25 basis points of funding when their paper trades at LIBOR plus 25bps in the secondary market.
This week's Learning Curve was written by Albin Spinner, v.p. at JPMorgan in London.
