CBOE Credit Event Options
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CEBOs (credit event binary options) were designed by Chicago Board Options Exchange to assist portfolio managers in actively managing their corporate credit risk if a credit event occurs. It is a type of hedging instrument which is inversely correlated to the credit worthiness of a single entity or of an entire market sector. As credit outlooks change, stemming from factors such as a rating agency’s formal assessment or market participants’ informal analysis, CEBOs reflect any additional risk by increasing in value as the corporate bond price decreases.
These products can be used by portfolio managers to actively manage/hedge their Credit Event risk without incurring large transaction and operational costs by constantly reshuffling their holdings.[1]
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How do CEBOs work?
What is a Credit Event?
CBOE recognizes events that are listed in the bond indentures, such as bankruptcy, failure to pay and debt restructuring, as Credit Events and specifies which of these apply to a particular CEBO on its listing date.
What is a Binary Option?
It is an option that pays a fixed amount if a Credit Event is confirmed and zero if no Credit Event is confirmed.
Who, when, how can credit event be confirmed?
CBOE determines Credit Events based on at least two information sources. These can be from a list of specified newswire or information services, and/or information submitted to or filed with the courts, the SEC, an exchange or association, the Options Clearing Corporation, or another regulatory agency or similar authority. To confirm Credit Events, CBOE has up to four days after the scheduled last trading day of a CEBO to determine and announce whether a Credit Event has occurred.
How are they quoted?
The effective price paid for a CEBO is 1000 times the premium based on a notional contract value of $100,000, which corresponds to ($100 X 1000). The contract’s price range is between $0 and $100, and it is quoted and trades in $0.05 intervals (e.g., $3.25, $3.30). At expiration, the value is either $0 if no credit event has occurred or $100 if a credit event has been confirmed.
CBOE Single Name CEBOs
These are security options that pay a fixed amount—$100,000 per contract—in the case where a credit event on an individual issuer or guarantor of debt securities is declared prior to the option's expiration. If there is no credit event declared before expiration, the option pays nothing.
CBOE initially listed single-name CEBOs linked to four Reference Entities: (1) Ford Co.; (2) GM Corp.; (3) Hovnanian Enterprises Inc.; and, (4) Standard Pacific Corp. As mentioned above, their payoffs are binary and the option is automatically exercised and pays $100,000 if CBOE confirms that the Reference Entity had a Credit Event between the listing date and the scheduled last day of trading. Contrarily, they pay $0, expiring worthless if no Credit Event is confirmed to have happened during this period.
Uses
Single-Name CEBOs can be used for various investment strategies, including, but not limited to:
- Hedge corporate debt with CEBOs. A portfolio manager can initiate a long position against the credit risk of U.S. corporate debt. Because these instruents pay a fixed dollar amount following the confirmation of a Credit Event, investors can buy CEBOs to convert corporate debt to Treasury quality without having to incur unnecessary transaction costs or encounter potential liquidity risk from reshuffling a portfolio.
Conversely, CEBO sellers can take on credit risk without having to buy corporate bonds and also without having to make an investment at the risk-free rate. This is a useful feature which can be implemented by overlaying CEBOs onto fixed income portfolios resulting in potential capital structure arbitrage or convertible bond arbitrage.
- Hedge equities with CEBOs. There is a significant inverse correlation between put volatility and share price. An alternative hedge to protect against adverse equity movements may exist with CEBOs, because of the high positive correlation that exists with put volatility.
- Hedge fixed-recovery OTC CDS spreads with CEBOs. These asset classes should have a close relation to each other because the recovery rate is predetermined and the differences between the two are primarily limited to the amortization of the option premium and suspension of the coupon payment after the confirmation of a Credit Event.
- Hedge generic OTC CDS spreads with CEBOs. When using this application, two variables are unknown, the default probability and the recovery rate. However, the recovery rate typically does not garner much value until the likelihood of a Credit Event occurring becomes more probable.
- Arbitrage credit asset swaps with CEBOs. Credit traders can arbitrage the basis between implied spreads in CEBO prices and the spreads of credit asset swaps in the same way that they arbitrage the basis between CDS and credit asset swaps.
- Adjust an index or basket’s composition with CEBOs. By incorporating a CEBO into a basket or index of CDSs or synthetic CDOs you can isolate a component and adjust your exposure by either reducing or increasing your risk level while leaving the remainder intact.
CBOE Basket CEBOs
These are call options based on a basket of reference entities (the basket components). The options automatically pay out a cash amount each time a credit event is confirmed in any of the basket components during the life of the contract. CBOE will determine when a triggering credit event has occurred, and resolution and payout is pre-determined and binding. After a payout, the basket component that had a credit event will be removed from the contract and the contract will continue on with one less entity in the basket. Subsequent payouts occur upon confirmation of credit events in the remaining components. The contracts will continue to trade until expiration or until all of the entities in the basket have confirmed credit events. If no credit event is confirmed in any basket component prior to expiration, the option will expire worthless.
A Basket CEBO is referenced to the debt securities of multiple Reference Entities. Examples are baskets referenced to the debt securities of corporations in the same economic sector or broad-based baskets referenced to the debt securities of corporations of the same credit quality. On the listing date, CBOE specifies the notional value of the basket, the components of the basket, their weights within the basket and their estimated recovery rates. For example, a basket could have a notional value of $100,000, ten equally weighted components, each with a specified recovery rate of 40%. A Multiple-Payout CEBO basket automatically pays a specified dollar amount each time that CBOE confirms a Credit Event in a component of the basket. The basket component is then removed from the basket and is not replaced. The Credit Event payout is equal to the notional value of the basket times the weight of the component that has the Credit Event times one minus its recovery rate. Using the same parameters as in the example above, the option would pay $6,000 ($100,000 X 0.10 X (1 - 0.4)) after each confirmed Credit Event. The sum of payout(s) would range from $0 to $60,000 depending on how many Credit Events are confirmed by CBOE over the life of the Basket CEBO.
Uses
Basket CEBOs can be used for various investment strategies, including, but not limited to:
- Hedge credit exposures to economic sectors, credit quality sectors or a cross-section of the market.
- Adjust the sector or quality profile of a broad-based CDS index.
- Hedge the sector or market component of the credit risk in a single name credit exposure.
- Hedge volatility exposures. The correlations between credit spreads, stock prices, and volatility typically rise during a financial crisis. This indicates that a long position in a broad-based Basket CEBO provides a hedge against the extreme volatilities that prevail when worst-case scenarios materialize. Even at low to moderate volatilities, VIX tracks speculative grade credit spreads.
Where to find probabilities of defaults
To assist in pricing methodology, different services estimate probabilities of default. Some of the most popular are Bloomberg, Moody’s KMV, Reuters, and RiskMetrics Group.
Probabilities of default can also be estimated from:
- OTC CDS prices
- Bond prices using Hull and White’s approach
- Equity prices using the Merton structural model or its variants
- Put option prices using either a structural model or a non-parametric algorithm
- Historical data
Resources
- CBOE CEBOs [[1]]
- Also see CBOE index options for a full listing of indexes traded on CBOE.
References
- ↑ "CEBOs on CBOE". cboe.com. Retrieved on Nov. 11, 2007.
