CDS premiums boost option participation in structured products

Participation rates and coupons in structured products are being boosted by premiums from credit default swaps (CDS) sold on sovereign and corporate entities, say dealers.

The trades, which are being sold to high-net-worth individuals and private banks in Brazil, Bahrain, Saudi Arabia and some European countries such as Greece, use the premium from selling credit protection on a sovereign or corporate to enhance the payoff of a structured product.

The trades are structured like any other products but include the extra premium from the CDS to purchase more participation in the option. If a trade was engineered as a principal-protected play, the protection would become subject to a credit event.

The recent activity is a result of the lack of participation that dealers have been able to engineer into products, given low interest-rate environments.

"Interest rates are extremely low and this has forced dealers to search for alternative sources of funding to achieve an additional pick-up in structured products," says one Paris-based structured products dealer. "By using the extra premium from shorting a sovereign, the participation in a product can be significantly enhanced."

The key policy rate of the Central Bank of Bahrain, the one-week deposit rate, stands at 0.75%, down from 2% on July 23 last year. The European Central Bank rate is 1% down from 4.25% on the same date, while the Brazilian key policy rate, the Selic, is 9.25% down from 13%.

CDS spreads on sovereigns have also widened during the financial crisis, ballooning since September last year. On September 1, 2008 Bahrain traded at 132bp, Greece 50.7bp and Brazil 129.9bp. On February 18 this year Bahrain was priced at 714bp, Greece at 260.2bp and Brazil at 383bp. Spreads have since narrowed but are still trading well above pre-crisis levels. On July 3 Bahrain traded at 350bp, Greece at 134.23bp and Brazil at 181.18bp.

See also: Structural shifts
A return to structured products