Equity default swaps are referenced to an underlying stock, and allow investors to hedge out equity risk or to speculate on a company's credit-worthiness. They have very similar features to digital options, paying out a pre-arranged amount, typically around 50% of the underlying, if the reference entity drops below a certain trigger, typically between 50% to 70% of the initial value. But JP Morgan Chase said its equity default swaps differ from a normal digital option due to their similarity to the credit default swap-like structure. And the US bank is marketing the instrument as a tool to accompany credit default swaps. Equity default swap protection buyers make regular payments through the life of the option, unlike the one-off payment of a digital option, said Peter Allen, head of JP Morgan Chase's European equity derivatives strategy group. Allen said this reflects the amortising payments of credit default swaps. The product, which has been marketed by the bank for the past two to three months, generally trades at much higher spreads than credit default swaps, reflecting the greater risk of the underlying event occurring, said Allen. For example, a typical equity default swap on Deutsche Telekom is likely to trade at around 435 basis points, compared with its equivalent credit default swap, which would trade at around 127bp. “Comparing equity default swap and credit default swap spreads allows investors to choose the most attractive vehicle for taking or hedging credit-like exposure,” said JP Morgan Chase in an analyst report.
But other bank analysts were sceptical about the product, saying equity default swaps are very similar to traditional digital options. "This is not a new product," said Johan Groothaert, head of structured and investment products within global equity derivatives at Deutsche Bank. "We have seen similar digital deep out-of-the-money puts with knock-in features before."
JP Morgan Chase said the 'equity default swap' name is a proprietary term developed by the bank itself, but hopes the product will catch on in the wider market. "This is a new avenue and has high growth potential – it could quickly develop into a liquid and tradable spread market acting as the equity equivalent of the credit derivatives market," said JP Morgan Chase’s Allen.