Credit spread option payments are triggered by price events rather than credit events A credit spread option is a financial contract that gives one party the right to buy or sell an underlying security at a variable price based on a predetermined spread (or strike) above a reference index (such as Treasuries or LIBOR). Credit spread options can be traded outright, or embedded in callable and putable asset swaps
Credit spread options have a higher likelihood of exercise than default swaps on the same bonds. A spread option written with an out-of-the-money strike begins to resemble a default swap with respect to the likelihood of exercise. However, the magnitude of the economic loss when a written spread put option is exercised is lower on average. For example, if an investor writes a spread put option that gives Merrill Lynch the right to "put" an 8.5 year non-investment grade bond to them at a price equivalent of Treasuries + 300 bps, and the bond subsequently trades at T + 400, the investor has an economic loss equal to the present value of 100 bps for 8.5 years (approximately 5.8% today). This is a much smaller loss than one would expect upon exercise of a swap conditioned upon the occurrence of an event of default. In this case, the average loss on senior unsecured bonds would be 52%, according to Moody's.
Both credit spread options and default swaps exist because of different investor preferences. Some investors are more averse to the likelihood of the occurrence of any loss, regardless of its size. Others concentrate on the magnitude of the possible loss versus the potential trade profit. While a credit spread option and a default swap may have the same expected gain (fee collected minus probability of a loss multiplied by the magnitude of a loss), investors may not be indifferent to the structures.
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In addition to the benefits described above for single bond default swaps, portfolio defaults swaps offer investors relative value and a unique type of leverage. More over, investors cannot economically replicate portfolio default swaps in the cash markets.
■ An Example
The most common application of portfolio default swaps is the purchase of second loss protection on large loan portfolios by commercial banks. Although not necessarily explicitly rated AAA, these second loss tranches are structured to achieve premium investment grade ratings. Commercial bank buyers retain the first loss exposure to reduce the cost of the hedge that is purchased to reduce the regulatory equity supporting the portfolio. In the table below, we detail a number of these structures that have been recently transacted, referred to in the marketplace as "synthetic CLOs".
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Portfolio default swaps segment the risk associated with a portfolio of credits linked to several credits among multiple investors. Portfolio default swaps are broken down into two main
categories: 1) first loss swaps; and 2) first-to-default swaps. First loss default swaps measure realized losses in dollars while first-to-default swaps measure losses in discrete events.
Portfolio default swaps can be traded outright or can be embedded in special purpose vehicles to create a funded asset. Default swaps based on portfolios use technology originated in the Collateralized Debt Obligation ("CDO") markets. The first-to-default or first loss swaps can be compared to the "equity" portion of a CDO. The second-to-default and second loss tranches of portfolio default swaps are analogous to the senior tranche of securitizations such as CDOs.
Buyers of portfolio default protection are motivated to retain a portion of the risk in existing portfolios and to reduce the absolute cost of hedging existing credit risk. Sellers of portfolio protection are attracted to the customized risk/return profile of the resulting exposure - the non-recourse, convex, enhanced spread of first loss positions and the over-collateralized low-risk nature of second loss positions.
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