CreditTrade prepares credit volatility pricing tool

CreditTrade is developing the pricing algorithm with a risk technology vendor, which Console-Verma declined to name, and several academics. It is targeted to show theoretical values for cancellable default swaps and – presumably in the future – other options on credit default swaps.

One hurdle facing the project is deriving implied volatilities for option pricing from short, and in some cases, patchy, credit default swap price histories.

According to Console-Verma, currently the most common cancellable default swaps offer five-year protection, but in exchange for around a 30% premium added to the price of a plain vanilla default swap, they give the purchaser the right, at six-month intervals, to put the swap back to the seller and cancel the contract.

Potential sellers of these options could be large credit investors that typically buy and hold assets but look to pick up extra income by selling volatility at the right price. This is termed the covered call strategy.

Cancellable credit default swaps for 20–25 European names are now strongly bid, said Console-Verma. The strongest users are bank loan officers seeking to hedge the call risk in loan facilities, and bond investors seeking a more accurate means of timing credit risk hedges for puttable bonds.

What is currently missing is the offer side, and the new pricing algorithm is meant to address this issue. By continuously showing theoretical prices, Console-Verma hopes to bring greater comfort to potential sellers of credit default swap options and spur the market.

The development comes as more dealers are looking to a next generation of credit derivatives products based on volatility. Volumes on credit default swaps are now large enough to allow dealers to think about delta-hedging credit default swap options market-making.

Though London is acknowledged as leading the way in developing the new credit volatility market, dealers in New York are also growing more interested. "I think the Street in general is looking to add a new arrow in the quiver, which is basically volatility as a product in and of itself," said the head of credit derivatives trading at one leading US dealer.