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Credit-default swaps are well established in the debt market as hedging instruments against credit risk and to enable market participants to establish a synthetic short position in a specific reference credit and implement credit-trading strategies outside the cash markets. The most common method of pricing default swaps is by recourse to the asset-swap spread of the reference credit, as the default-swap premium should, in theory, be equal to the asset-swap spread of the reference asset. We first consider the use of this technique, before looking at the issues arising that cause these two spread levels to differ.

Five-year credit-default protection on Nokia continued to tighten last week, outpacing its European mobile peers as strong collateralized debt obligation bids pushed in credit spreads on the world's largest handset maker. Nokia had tightened about five basis points to roughly 30-40bps last week, prior to an Enron-induced widening which pushed the entire European market out five basis points further. Traders said Nokia had tightened considerably in the last two weeks or so, as a handful of structurers assembling CDO assets picked the credit. "Investors don't like Ericsson and Alcatel anymore, but because of diversification requirements you need telecom in there and Nokia has become a real favorite," said one. At its widest earlier in the year, Nokia traded at 70bps, while Alcatel was at 360bps. The entire sector has tightened, but Nokia has come in about 60% in comparison to Alcatel's 30.

Interest-rate traders expect volumes in the Asian interest-rate markets, particularly in Hong Kong, Singapore and Korea, to surge after New Year, as customers enter derivatives on the belief that rates are bottoming out. "There will be a dramatic pickup," said Rinesh Mehta, exotic and plain-vanilla options trader at BNP Paribas in Singapore, adding, "volumes in the [Asian] option markets will increase by 50-75%." Average daily volume in the Hong Kong interest-rate options market is currently around USD3-400 million. Mehta continued that corporates, which have been on the sidelines waiting for rates to bottom-out, have started inquiring about entering interest-rate derivative transactions at the onset of 2002.

Lehman Brothers is advising clients to follow a stock replacement strategy that utilizes call options to replace some or all stock positions, which have rebounded from the effects of the slowing U.S. economy and the impact of the Sept. 11 attacks. Investors who think the U.S. equity market may crash before year-end should opt for this trade, according to, Paul Lieberman, v.p. of equity derivatives and quantitative research in New York. He explained it locks in the stock gain by selling some of the stock and maintains upside exposure with the rest. Being a defensive strategy the loss in the call option is limited to the premium paid, he added.

Fortis Bank Hong Kong is reorganizing its derivatives effort following the resignation of Tony Au, head of capital markets in Hong Kong, two weeks ago. Philippe Dirckx, head of interest-rate derivatives in Hong Kong, has been promoted to head of fixed income and has assumed Au's responsibilities. "We're in the middle of a restructuring phase but next year our focus will be on credit derivatives products," said Dirckx.

Traded volumes of credit-default swaps referenced to Enron's financial backers J.P. Morgan Chase and Citigroup increased five fold on Thursday amid concerns that Enron was going to file for bankruptcy. The activity picked up after the two firms announced their decision to invest an additional USD500 million between them in the company that would be created were Enron and Dynegy to merge. They have already invested USD1 billion. Officials at the firms confirmed the investments.

Westpac Banking Corp. and Deutsche Bank are separately structuring their first synthetic CDO transactions for New Zealand investors and expect the deals to hit the market in the coming months. Westpac is looking at structuring a CDO on a portfolio of solely Kiwi names, which would be a first, but Deutsche Bank expects to have a global portfolio which would include several Kiwi credits and be marketed in New Zealand, according to officials at both firms.

Southern Electric is looking to enter an interest-rate swap to convert a 30-year GBP250 million (USD352 million) fixed coupon bond it issued last month into a synthetic floating-rate liability. The utility is looking to enter a swap in which it receives a fixed rate equal to the 5.50% coupon on the bond and pays a floating rate of less than 50 basis points below LIBOR, for more than half of the principal. Gregor Alexander, group treasurer of parent company Scottish and Southern Energy in Perth, U.K., said the company should be able to achieve such a rate through the use of a structured swap, such as a callable structure. He declined further comment about what other types of structured swaps the issuer is considering.

The unwinding of swaps and futures led to massive movements in the over-the-counter interest-rate derivatives market last week, as some hedge funds and proprietary desks sold in advance of the end of the month when many, particularly in the U.S., close their books for the year. The activity led to substantial moves in all swap spreads. For example, in the U.S., the more liquid two-year spreads widened to 3.8% from 3.52% last Tuesday, a huge move when compared to the daily average of roughly seven basis points, according to traders and strategists. A relatively benign week of U.S. economic figures also contributed, leading punters to speculate interest rates may start to raise early next year.

Madison, Wis.-based Alliant Energy recently hedged a portion of its weather risk for the winter by buying a heating-degree-day put on the average temperature in Madison from November through March, said Bill Zorr, general manager of gas trading. In the transaction, Alliant will receive a payout from Hess Energy Trading Co. if the temperature is warmer than the 10-year average in Wisconsin. Zorr declined to specify the exact sum the company will receive, but said it was enough capital to cover the lost revenue the company would have received if it sold gas to customers during a cold winter. If the winter is colder than the 10-year average then the deal expires out-of-the-money.

Global Asset Management (GAM) plans to add to its holdings of French, German and Italian sovereigns. Ron Tabbouche, London-based portfolio manager, says it will wait for European government bonds to bottom out before making the move. Once the yield on U.S. Treasury five-year paper reaches 5.25% and German five-year paper is at about 5%, the firm will put some of the cash in its $250 million global bond portfolio to work. Last Tuesday, the German five-year note was yielding 4.25% and the U.S. five-year yielded 4.33%. He declined to specify exactly how much would be rotated into the sector. GAM will seek to add longer-dated paper, anywhere from five years and up, because he says short-term interest rates will continue to decline, and that, coupled with inflation, should lead to curve flattening.