Credit derivatives market will follow equity's lead, strategist says

Mahadevan told Risk News that high equity volatility has led to increased use of equity options – and, similarly, high levels of tail risk in the credit markets could lead to more sales of credit spread options.  The future of credit derivatives trading, he predicted, will be in  'delta-one' products, debt/equity hybrid strategies and credit optionality, rather than securitisation.

"We believe that the natural seller of protection is not going to come from the securitisation model that we have seen in the past, but will evolve towards a framework that is similar to what we see in the equity markets – the creating and trading of portfolios of equity risk which is either not levered, or levered to a minimal degree: exchange-traded funds, equity futures and swaps," Mahadevan said.

In a sense, this is a return to the roots of credit trading: the creation of the credit default swap (CDS) indexes in 2000 and 2001 led to initial interest in delta-one instruments, although this was soon overtaken as the momentum for securitisation picked up – with spreads tightening, investors sought more leverage, which led to the popularity of complex products such as synthetic collateralised debt obligations. Now, however, if spreads remain wide, and correlation falls as sectors distinguish themselves in terms of relative performance, the market could see increased demand for more sector-specific indexes in investment grade and high-yield credit markets, according to Mahadevan.

Another possible strategy is driven by greater credit volatility in the various parts of the capital structure, combined with the idea that companies that are very similar can have very different corporate capital structures. This lends itself well to valuing companies on an enterprise-value basis, he  suggested: trading the enterprise value of companies could become more common via debt/equity hybrid structures, such as the combination of an equity swap paired with a series of CDS contracts referencing the debt portion of the capital structure, effectively a new way to trade companies in the market via swap form. 

See also: Primus downgrade prompts questions over CDPCs
A free lunch and the credit crunch
  • LinkedIn  
  • Save this article
  • Print this page  

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an indvidual account here: