Violent swings across financial markets have forced investors to re-evaluate portfolio allocations, as well as hedging practices. TABB Group’s new Market Note,“Broken Hedges: Credit Traders and the Lure of Equity Options,” examines why credit investors are turning to equity options as hedging tools, and what specific products these investors are using the most.
Report author Callie Bost reports that while the US corporate bond market is expanding, the availability of credit-default swaps (CDS) is dwindling. Last year, the notional value outstanding in the US corporate bond market was USD8.1 trillion, more than double the amount in 2002, according to Federal Reserve data. There was about USD14.6 trillion worth of CDS contracts outstanding in June 2015, down from USD58.2 trillion in December 2007, according to semi-annual data from the Bank for International Settlements.
As the research explains, this imbalance has heightened the credit market’s concerns about the potential for a liquidity crisis in the event of a rapid drawdown. In addition, credit traders looking for higher income generation in tumultuous markets have expanded their use of broad-market index and ETF options, as well as single stock options offering exposure to single company risk.
“Regulatory restrictions and capital requirements for US banks stemming from the Basel III accords have crimped their ability to deal over-the-counter (OTC) credit derivatives, including CDS contracts,” says Bost. “Additional mandates, such as the liquidity coverage ratio, the net stable funding ratio and certain provisions of the Volcker rule, as well as the need for high-quality assets as collateral, are further limiting these banks from operating as traditional providers of liquidity and immediacy in the OTC market.”
