Sunday, May 15, 2005

Credit derivatives and volatility

Longtime readers of this blog know I have been puzzled over low implied volatility in equity markets over the last year or so. Recently we've had a spike in volatility (see the VIX index which tracks implied vol on the SP500), and this recent PIMCO report on credit derivatives suggests one explanation for recent behavior (CDS = credit default swaps; credit derivatives are valued by assuming a link between the volatility of the stock (e.g. GM) and the probability of default on the corporate debt (credit risk), hence the correlation trade strategy B described below):

"Interestingly, hedge funds are the largest users of credit derivatives and CDS. Several of the largest Wall Street firms estimate that 50-60% of their current trading volume in CDS is with hedge funds. These leveraged funds use CDX index products to gain a diversified exposure to credit, thus earning positive carry. Two trades, which have been popular with hedge funds, are long CDX index products/short individual CDS names (Strategy A) and long CDX index products/short equity calls (Strategy B).

...Strategy B is an income generation strategy (which is also being implemented by $10 billion closed-end income generation funds started in the past year). This strategy seeks to produce income via long exposure to spread product, yet gives up any large equity upside by selling calls. Both hedge funds and closed-end funds have been aggressive sellers of equity call options over the past year, suppressing implied equity volatility. This created an illusion of calm waters. However, as soon as equities fell and volatility spiked, these calm waters got surprisingly rough in a short amount of time as investors shifted into "risk reduction" mode and unwound long credit positions, bought equity put options and bought protection on CDX index products. This leveraged unwind trade caused credit spreads to widen sharply, put downward pressure on stocks and caused implied volatility on CDX options to spike."


Anonymous said...

Do you have any other articles or info on credit derivatives pricing or trading? I found some interesting information on the following sites:

Anonymous said...

New York Attorney General Andrew Cuomo has subpoenaed eight interdealer brokers to produce data and other communication regarding their activities in credit default swap trading. People familiar with the situation say Cuomo, as well as the Securities and Exchange Commission in a separate inquiry, are looking to identify dealers who during August and September may have spread false information to manipulate CDS prices. Two of the exchanges uncovered were emails between Marcos Brodsky, a partner at Phoenix Partners, and Roman Shukhman, a credit derivatives trader at JPMorgan. According to documents, the first email from Brodsky suggested Goldman Sachs was looking to sell a CDS index position, while the second one, from Shukhman asked about seeking notification for when a Deutsche Bank had entered the market

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