CDS and Exotic Options

Ever heard of exotic options, like barrier, knock-out, and knock-in options. Lets try to distinguish them.

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.

4 thoughts on “CDS and Exotic Options

  1. So i’ve read some of your blogs Sandeep, and while you write in layman terms, which is always beneficial to the peripheral reader, your knowledge seems high-level at best and usually you’re writing about a subject that you seem to know nothing about, but that you have read something in recently to make you think that you are dangerous. Therefore the information you wind putting on paper is usually misleading, and evident that it is recently read. For example:

    “usually higher than the credit spread inherent on a corporate bond of the same maturity.”

    Have you ever heard of negative basis trades. The word “usually” above is not true. I have traded credit derivatives, while it seems you have just read about them.

    Take another example:

    “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. ”

    That is true for any product, be it an option on WTI or a large equity derivative trade.

    It seems that you are in India? All i ask is if that you are going to blog about a topic, understand it considerably before you go blabbing about it all over the internet. You have never traded credit derivatives or exotic derivatives (or even structured or sold them), so how do you know all the above? Reading something and writing about it is simply regurgitating someone’s opinion and if you don’t cite it, is actually plagiarizing. Please be careful what you write and spread.

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  2. Oh yes – and while i agree with you that the CDS is market is influenced by technicals, there is no real better approximation of the probability of default of a reference entity. Yields (or z-spreads) are an unlikely indicator as these are cash instruments, with lots of liquidity problems, as well as technical nuances of their own (insurance companies and pension funds). Bonds have covenants and nuances that affect the credit spreads so they are not a true approximation of credit risk due to the underlying personality of the bonds. CDS are standardized instruments.

    The CDS market is not all driven by speculators, there is actually a lot of hedging. But let’s say it is and examine the bond market in greater detail. Because bonds are hard to short, yields are usually lower as there are no natural shorters but just buyers or unwinders. Mostly however, bonds are traded long due to the insatiable demand of real money accounts for yield. So yield is then artificially driven lower, thereby decreasing the probability of default.

    Please please have more knowledge before you write something… Also, if the bond is below 80 does not mean there is “trouble” but rather that the bond is not paying a coupon commensurate with it’s risk. This could simply mean that the company is not in trouble, but that yield in the economy have increased, that this particularly bond was issued when rates were low, and therefore it’s coupon is low and discounted at a higher rate. Does not mean that the entity is in trouble.

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  3. Thanks for your views, Indeed I may not be right in citing the example as I have never traded CDS, since the are not traded in India. But I have traded Commodity futures on Nymex, spread of Bonds & Notes. But there is nothing wrong in forming the opinion, as the people like you make me educated. Thanks once again !!

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  4. Interesting – my naive view was always that the yield on corporate bonds was zero-risk plus default risk, and the CDS cost was just the default part cut out, so that buying a CDS as a hedge effectively gave your bonds the credit rating of your counterparty.
    So then why couldn’t the CDS dealers hedge off anything they don’t want by shorting the corporate bonds in the spot market and buying treasuries? Is there no borrow available?

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