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Credit index options--or credit swaptions as they are often referred to--came of age during the credit crisis, with liquidity picking up significantly since. Net notional outstanding currently stands at USD80 billion with trading volumes reaching up to 500 trades a week.
This growth in notional follows the increased liquidity of the underlying credit default swap index market, which has helped reduce the cost of hedging options. It can also be partly attributed to the standardization of the CDS index option market following the introduction of standard Markit index trading documentation.
The players active in this market are hedge funds and real-money managers, as well as proprietary trading desks and risk managers. They can be categorized as spread hedgers, who are generally buyers of payer options to hedge the widening of spreads; convexity hedgers, who use options to hedge negative convexity on spread moves; and volatility players that take a view on volatility using credit index options.
In this Learning Curve we describe the mechanics and basic pricing principles of credit index options, market conventions as well as basic trading strategies.
Mechanics
Credit index options are based on Markit's most liquid North American and European credit indices. In North America, options on the Markit CDX Investment Grade, the Markit CDX High Volatility and the Markit CDX High-Yield are liquidly traded.
In Europe, traded CDS index options are based on the Markit iTraxx Europe set of indices: the Markit iTraxx Europe, the Markit iTraxx HiVol, and the Markit iTraxx Crossover.
Similar to the interest rate market, two sets of vanilla CDS index options are traded:
1. A payer option where the holder has the right, but not the obligation, to buy protection on the specified index at a defined spread on a given future date.
2. A receiver option where the holder has the right, but not the obligation, to sell protection on the specified index at a defined spread on a given future date.
Essentially, a payer option is a put option on the market whereas a receiver option is a call option on the market. The defined spread referred to above is also known as the option's strike: the future date on which protection can...