“In our numerous discussions with capital structure arbitrageurs in the hedge fund community, we found a lot of reliance on using historical experience to compute deltas on a forward-looking basis,” said Morgan Stanley in its report, Puts vs Protection – The Delta Divide, written by fixed-income analysts Sivan Mahadevan, Peter Polanskyj and Anisha Ambardar.
Selling out-of-the-money equity puts while simultaneously buying credit default swaps on the same name positions a hedge fund manager for a recovery in the stock level, but also provides downside protection on the debt. This requires ‘weighting’ the trade by calculating the delta – the hedge ratio – between the two instruments. For example, a 25% delta would mean $4 million notional of credit default swaps would have to be bought against a $1 million notional sale of equity put options.
Morgan Stanley calculated so-called 'optimal deltas' – those that gave minimum profit and loss and therefore came closest to a perfect hedge – for 76 companies over 15 months, and found that the ideal delta varied with absolute spread levels.
“Tight credits are not very volatile in credit markets, so more protection is needed to hedge the movements in the equity put options,” said the report. “Also, outgoing premiums are low, so more protection can be funded/hedged by the sale of equity put options. On the other hand, wide credits are more volatile, which means less protection was required to hedge the profit and loss of the package trade.”
Morgan Stanley argued that, according to its study, this spread and delta relationship should be regarded as a rule-of-thumb for capital structure arbitrageurs.