In finance, a barrier option is an exotic derivative typically an option on the underlying asset whose price breaching the pre-set barrier level either springs the option into existence or extinguishes an already existing option.
Where the option springs into existence on the price of the underlying asset breaching a barrier, it may be known as an “up and in,” “knock-in,” or “down and in” option.
Where the option is extinguished on the price of the underlying asset breaching a barrier, it may be known as an “up and out,” “knock-out,” or “down and out” option.
Barrier options are always cheaper than a similar option without barrier. Thus, barrier options were created to provide the insurance value of an option without charging as much premium. For example, if you believe that IBM will go up this year, but are willing to bet that it won’t go above $200, then you can buy the barrier and pay less premium than the vanilla option.
Having understood the above than why one should take that risk?
But if you see the other side of the trade, It would be an attractive proposition.
Asymmetric payoffs are typically favored by those that can earn a lot, even if the odds are small.
The same is true of Credit Default Swaps [CDS]. There are a lot of players that want to speculate on the demise of companies, hoping for a big payout, even if the odds are small, partly because the amount they pay to gamble on the risk is also small.
The markets for single company CDS are thin because there are few natural counterparties that want to nakedly go long credit risk. Those wanting to nakedly short credit risk therefore have to pay a premium to do so, usually higher than the credit spread inherent on a corporate bond of the same maturity.
And if one or two hedge funds want to do it “in size,” guess what? The dealers in the CDS market will back off considerably, and make them pay through the nose. No dealer wants to take the risk that an informed trader knows something he doesn’t. They will raise the levels that one would have to pay to bet on the risk so high that some others might be willing to take the other side of the trade.
Now some investment journalists naively think that there is a strong correlation between CDS prices and probability of default. The CDS market is a thin market, for reasons mentioned above. Before I would say that there is a “creditor panic” going on, I would look at the corporate bonds of the company in question, and see if the yield spreads are “blowing out.”
Typically, the CDS market is quick to react, but with a lot of false signals. The corporate bond market is slow to react, and sometimes misses problems.
When talking about default, you need to spend more time on the bond market and less time on the CDS market. Yes, the CDS market tends to lead the bond market, but this relationship has a lot of noise, and offers a lot of false positives. Far better to look at the bond market. When the bonds of any company drop below $80 per $100 of par, there is trouble, and usually a juicy story, with considerable concern as to whether the company can survive.
The CDS market is driven by speculators who are probably right more often than wrong, but not by a large margin. To the financial media, Avoid using that market to write stories, because it only lends to sensationalism, and does not reveal imminent trouble, unless the bond market agrees.