Folks,Can someone tell me if there is a market in credit default swap options.Any other comments welcome ( potential for these, pricing issues, participants in that market, etc. )Cheers Cheers, Eng.

I am not sure whether a market exists for those credit default swap options yet.But don't worry, we are already working on the tool to calibrate to their prices.(For we think credit default swap options are the missing information to calibrate stochastic credit spreads, or correlation thereof with equity).

Nobody trades cds options, really. Any "quotes" u see are going to be lies. The current practicioner technology in this area is pretty pathetic and relies primarily on explicit modeling of the SPREAD itself rather than its endogenous extraction via a firm-value framework. Trying to manage your risk or price optiosn in that manner is plain stupid. The dealers realize this and therefore dont' really provide any liquidity on any of this stuff.You can't even get "real" quotes on cash bond options.One last point is that the biggest demand for this type of product is NOT a simple euro option on a cds. It's for extension options that allow you to extend a cds past its original contract terms at the same running rate. The guys that want this are the convert arb funds, who want to buy protection to the first put date in their converts but also want to be able to extend that protection to the second put if the bond makes it past the first one.The underlying pricing technology on credit spreads is so bad right now, though, that I really think people are getting WAY ahead of themselves by looking at cds options right now. All that's going to happen if this product does take off without the proper understanding of the dynamics is a pre-87 equity options scenario where people take down size model risk without even thinking about it.

QuoteThe guys that want this are the convert arb funds, who want to buy protection to the first put date in their converts but also want to be able to extend that protection to the second put if the bond makes it past the first one.I'm with B2 on this one. There are not too many people that want the option to either lay off credit risk or assume credit risk at some given spread in the future. That's because credit risk is quite narrow and ties in with very specific transactions. If someone is holding a default option they have only a very small number of activities that they can undertake to hedge out that position. With something more generic like an interest rate option or a FX they have a lot more possibilities for hedging out. Having a number of business purposes in mind when trying to hedge out a hard to price option helps take some of the sting out of perhaps paying too much up front for it. Put another way, if I have the possibility to loan 50MM to either GE, CSX or BAYER at some point in the future where is my money best spent? Hedging out the interest rate exposure with an option on 50MM or hedging out credit exposure with three options on 50MM?? I'm not saying that they will never happen, I just think it's a long way off. I've been wrong once before though One area that I think will see incredible growth is changing notional swaps. Banks are looking for decent ways to take care of the credit lines they provide to companies. Counterparties that can take a varying amount of exposure (think insurance companies) should make decent coin from writing these kinds of swaps.

I have seen contracts on Asset Swap with termination feature, do you think an option on an asset swap is similar in nature to an option on a CDS?

RowdyRoddyPiper,Can you please explain in a few details what "changing notional swaps" are? As I can see from the name changing notional means just the option to require the borrower to pay out a part of the debt before the maturity. But how does it differ from options on bonds (given the debt is represnted by bonds)?Thanks!

I agree on the counterparty hedging issue... We used to have a lot of Argentine folks with big ccy swaps. The hardcore quants out there who think they're going to get fat by introducing a predictable wrinkle into the credit markets should take a good hard look in the mirror and admit that they don't know the market. We're talking about a world where you can still arb cash bonds against CDS fairly often. Think about how successful you'd have been if you tried to dynamically hedge options on some of the well-known spread wipeouts of the past 18 months - the spread process would have killed you if the liquidity potholes didn't.

Kr,I most definitely agree with you. The CDS market is still in it's infancy, anyone who wish to delta hedge a CDS option has gotta factor in an enormous hedging cost. For some ref entities, just crossing the spread will cost you an arm and a leg. I am constantly surprised when dealers found out that the counterparty quoted them an absurd rate to square his position and there is only one counterparty who is willing to quote this ref entity.

Yes, you can find in the market callable CDS that contain implicitly bermudan options. But this market is still in it's infancy because of enormous transaction costs and enormous volatility of CDS premiums ( sometimes it exceed 150% ! )

Having a fully implemented pricer for european and bermudan options on cds underlyings, the question is thenhow to calibrate the mean reversion rate and volatility (both for the cases of the hazard rate beingmodelled by a Hull White process d\lambda_t=(k(t)-a \lambda_t) dt + \sigma d W and a Black Karazinskyprocess d log(\lambda_t)=(k(t)-a log(\lambda_t)) dt + \sigma d W).Given that the data I have are historical credit spreads, how do I get the mean reversion rate "a" andthe volatility sigma? Do I1) Invert somehow the historical credit spread into an historical hazard rate and calculate itsmean reversion and volatility? If so, how do I invert the complicated expression for the price of acds into the hazard rate. It does involve Expectation[e^{-\int_t^T \lambda_s ds}] so not easy really...2) Relate analytically the mean and variance of the spread to the mean and variance of \lambda_t?Again the problem is the convoluted way the credit spread depends on the hazard rate \lambda_t...Any clues?Eurico

JP and Morgan are pushing hard on tracers, or tracx, whatever it's called now. They really want to make a market in options on these cds index products. Obvioiusly that would be very lucrative for them, but do they have the muscle to create demand? Possibly. I'm not sure, wondering if anyone else thinks they can make this happen just by wanting it bad enough.I'm hearing traders say they want to do extendable, cancellable, and constant maturity cds contracts, and damn the gamma risk.I don't even think it's gamma, it's a completely discontinuous jump risk.Now they want to securitize the desk P/L and buy "first loss" protection against this market blowing up in their faces.It just keeps getting better.

there's another dimension to the tracers/tracx issue... even before HYDI came out (but after the failed ECSI), there were concerns about transparency. Obviously the objective was to rip off clients when the market was young and nobody knew what you were supposed to pay. Then there was FAS133 and you had to give them something. One way to do this would be to just mark against an index... so if the HYDI-type products became liquid, you could make money on the flow over there and still screw the clients on the single-name stuff. Then they came up with the CreditGrades thing, or whatever it was called before it turned into a JV. Do we see a pattern? By now, I think the market is competitive enough on the mainline stuff, but people who need name-specific in more unlikely areas can still be scammed. The name of the game over there was/is to keep the transparency as low as possible.HYDI was a hot product from the beginning, with some technical snags. Actually, the ECSI came much earlier (12-18 months) but it was run by the research guys in London. They did everything by the book, and when they couldn't meet the requirements because of poor liquidity, they gave up. When I was running our internal-only index before HYDI, people were really interested - especially guys doing new deals so they could back up their market pricing to clients, and economic research types who could start to do more specific statistics. But it was all sort of off-the-cuff, informal stuff (i.e. like HYDI). Even now there is a big debate about all this (this month's US Credit mag, the one with Bill Gross having a bad hair day). None of management ever said the words, "We wanna trade options on credit indices." But it was such a conspicuous absence that you knew: this was exactly where they were going. I was long gone by the time tracers became tracx (after 'tracers', 'tracx' makes me think of a heroin addict) but I think the issue is still a liquidity thing. If you are holding down transparency everywhere you can, liquidity is gonna be poor. The only reason to join up with MS would be to generate very specific liquidity in this kind of product, and nowhere else. So when you say 'It just keeps getting better', well, that's precisely my sentiment on all this. If anything, these guys have to be worrying about losing their hero status if/when the economy turns around.