With volatility so low and risk seemingly removed from any- and every-one's vernacular, perhaps it is time to refresh our perspective on downside and tail-risk concerns. While most think only in terms of equity derivatives as serving to create a tail-wagging-the-dog type of reflexive move, there is a growing and increasingly liquid (just like the old days with CDOs, so be warned) market for options on CDS. Concentrated in the major and most liquid indices, swaption volumes have risen notably as have gross and net notional outstandings. Puts and Calls on credit risk - known as Payers and Receivers (Payers being the equivalent of a put option on a bond, or call option on its spread) have been actively quoted since 2006 but the last 2-3 years has seen their popularity increase as a 'cheap' way to protect (or take on) credit risk - most specifically tail risk scenarios. Morgan Stanley recently published another useful primer on these instruments - as the sell-side's new favorite wide-margin offering to wistful buy-siders and wannabe quants - noting the three main uses for swaptions as Hedging, Upside, and Yield Enhancement. These all have their own nuances but as spreads compress and managers look for ever more inventive ways to add yield so the specter of negative gamma appears - chasing markets up into rallies and down into sell-offs - and the inevitable rips and gaps this causes can wreak havoc in markets that have momentum anyway. Given the leverage and average notionals involved, understanding this seemingly niche space may become very important if we see another tail risk flare and as the Fed knows only too well (as it suggested here [13]) like selling Treasury Puts, derivatives on credit are for more effective at establishing directional moves in the the underlying than simple open market operations.
The hard-sell is back on to persuade the buy-side that now is the time to lever up those views:
As Swaption Volumes Outstanding has risen notably recently...
Three things should drive the choice of 'hedging' or leveraging instrument:
- Liquidity
- Correlation to Hedged (or desired exposure) Assets
- Cost vs Convexity
Credit Hedger's Liquidity Pyramid & Typical Trade Sizes
Credit indices: CDS indices, of which there are over 20 globally, remain the most liquid way to express a portfolio view in credit. The drawback is that the exposure is linear, meaning that the investor can lose money if the market improves, and hedging can be expensive if risk premium is already in the price.
Index options: Increasing liquidity, asymmetric payoffs and the ability to customize payouts define maximum costs at trade inception all have attracted investors to options for hedging. However, these are still very short dated instruments, with expiries in the 3m–6m range.
Credit tranches: Tranches are designed to express a view on defaults and risk premiums separately. Their long-dated nature makes them ideal when uncertain about the time-frame of events being hedged. These are also relatively liquid, and can vary in cost depending on the strategy. Unlike options these do have more than capped downside if the market improves.
Single-name CDS and baskets: Individual single name CDS and baskets are less liquid than the indices, but more “customized”. We like using this strategy to hedge exposure to highly specific exposures or risks.
The low cost and huge notional of credit options, while useful to hedge size, can lead to excessive moves exaggerating directional momentum - and perhaps helping to explain the consistent opening gaps in European (and US) credit markets during this rally. But getting a grasp on just how large a tail-risk move could be is a first step in deciding how much one is willing to pay for that protection.
Defining Hedge Scenarios:
Morgan Stanley find it useful to look at past credit sell-offs to assess the extent and pace of bear market credit spread deterioration. For the moment, we ignore the basis between cash and CDS. For CDS indices specifically, we have a more limited history than the broader credit market, but the examples we have show roughly the same intensity and trajectory as the underlying credit market for various market declines.
For investment grade indices a large tail scenario seems to be about 130bp of widening over five months from trough to peak, with the bulk of this in the two months preceding the peak (illustrated below).
In high yield indices,the equivalent move is around 400-600bp over a five month period with nearly 300bp of that in the 4-8 weeks before the peak.
What we find most interesting is the 'similarity' in magnitudes of these sell-offs and the gathering pace (as seen above) of the average move.
And so to summarize the 3 basic option strategies - we can hedge, take-on-exposure, or enhance yield in various ways (which we will discuss in the next installment) - but key to all of this is the position that the dealer is left with (and the client-side has to deal with) - as all options are sold initially delta-neutral (but they still have convexity or gamma).
There is no need to glaze over.
This means dealers (who are more generally writing options to the buy-side) will be short gamma and the client-side (the typical buyers of options) will therefore be getting synthetically longer in a rising market and shorter in a falling market. This can lead to rather excessive movements as we approach maturities (we just passed the March 20th roll) and if there are exogenous events (CB actions) that surprise one way - as these lead to a need to move large amounts of notional underlying index to maintain some semblance of hedge.
As volatility has dropped, there has been a growing call for the client-side to take on long-vol strategies - which implicitly offloads the negative gamma from the dealers (who given their larger books and flows are better able to manage around the position) to the buy-side, leaving them with hedges that need to be carefully maintained.
The point is - this is all ringing a bell - just as CDOs were created to fill a need and used by people who misunderstood them leading to some rather incredible consequences, we fear the growing use of Credit Swaptions could lead to similar paths should they grow unchecked - or at least, as we have seen in VIX-land, become complacent beyond the mere mortal abilities of the Central Bank to contain.
We will expand on these topics in Tail Risk Hedging 201: Credit later in the week.






