MS Credit Options May 2011 FINALweb.iacpm.org/dotAsset/31155.pdf · Any obligations of Morgan...

This material has been prepared for information purposes to support the promotion or marketing of the transaction or matters addressed herein. It is not a solicitation of any offer to buy or sell any security, commodity or other financial instrument or to participate in any trading strategy. This is a marketing communication. This is not a research report and was not prepared by the Morgan Stanley research department. It was prepared by Morgan Stanley sales, trading, banking or other non-research personnel. Unless stated otherwise, the material contained herein has not been based on a consideration of any individual client circumstances and as such should not be considered to be a personal recommendation. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Past performance is not necessarily a guide to future performance. Please see additional important information and qualifications at the end of this material.

Any obligations of Morgan Stanley should not be construed as bank deposits and are not insured by the Federal Deposit Insurance Corporation or any other governmental agency, nor are they obligations of, or guaranteed by, a bank.

Credit Options and ApplicationsLondon, May 2011

Jaime [email protected]

Discussion Material

FOR ELIGIBLE COUNTERPARTIES AND PROFESSIONAL CLIENT S ONLYCONFIDENTIAL – NOT FOR ONWARD DISTRIBUTION

Table of Contents / Overview

• Executive Summary

• Market Update

• Credit Option Basics

• Pricing Tools and Greeks

• Options Strategies

Executive Summary

4This material is not a solicitation of any offer to buy or sell any security, commodity or other financial instrument (or related derivative) or to participate in any trading strategy. This material was not prepared by the Morgan Stanley research department. Please refer to important information and qualifications at the end of this material

Executive Summary

• Since their creation in 2003, volumes in credit derivative options have increased exponentially, specially since mid 2007

• Currently, credit options have become a standardized and liquid instrument used different type of market participants.

• Credit options are constructed around two building blocks: Receiver and Payer Options, which can be assimilated to call and put options.

• Investors willing to implement more complex strategies use a combination of these building blocks

• In today’s presentation we plan to cover:

− Market Update

− Credit options basics, pricing tools and “Greeks”

− Specific option strategies for CPM desks

Market Update


Significant increase in credit option volumes

156

129

99100

64

Q1 2010 Q2 2010 Q3 2010 Q4 2010 Q1 2011

Total Options Volumes Traded by Morgan Stanley($ bn)

+143%

Source: Morgan Stanley, May 2011


Market Participants in Credit Options


Banks

Hedge Funds

OtherAsset Managers, Pension Funds, Insurers

73%

6%

18%

Credit Options Volumes Traded by Morgan Stanley(%)

Credit Options Basics


Building Blocks: Payer Options

• A Payer Option gives the holder the right to buy a fixed notional of CDS protectionon an underlying reference entity or index at a fixed spread level (“Strike Price”), on a fixed date (“Expiration Date”).

• To buy a Payer Option an upfront amount is to be paid (“Premium”)

• The holder of the Payer Option gains if spread of the underlying reference entity or index on Expiration Date is above the Strike Price

Source: Morgan Stanley

-150,000

50,000

250,000

450,000

100 150 200 250

Payer OptionPnL (for €10MM Notional)

Spread


Building Blocks: Receiver Options

• A Receiver Option gives the holder the right to sell a fixed notional of CDS protection on an underlying reference entity or index at a fixed spread level (“Strike Price”), on a fixed date (“Expiration Date”).

• To buy a Receiver Option an upfront amount is to be paid (“Premium”)

• The holder of the Receiver Option gains if spread of the underlying reference entity or index on Expiration Date is below the Strike Price


Receiver OptionPnL (for €10MM Notional)

(50,000)

0

50,000

100,000

150,000

200,000

30 50 70 90 110 130 150 170 190 210Spread

11

Standard Terms of Credit Options

[EUR] [�]Original Notional Amount

iTraxx® Europe [index name] Series [�] Version [�]Index

[�]Expiration Date

[�] per cent per annumStrike Price

[EUR] [�]Premium

Party BSwaption Buyer

Party ASwaption Seller

Sample terms and conditions of Credit Options

• Underlying: iTraxx Main, iTraxx XOver, SovX, iTraxx Fin Snr, CDX IG, CDX HY and MCDX.

• Underlying Maturity: Typically on-the-run 5y maturity

• Expiration Dates: 1m – 6m on 3rd Wednesday of the month

• Premium: Quoted as upfront amount. T+3

• Strikes: Quoted on spread for most indices, with the exception of CDX HY. Range of ITM, ATM and OTM strikes quoted

• Delta exchange: Yes, at a hedge ratio. No-delta options also available

• Option type: European payoff, the options are only capable of exercise on the Expiration Date

• Settlement Type: Physical settlement. The option buyer has the right but not the obligation to enter into a CDS contract at the strike spread with the option seller. There is a window on Expiration Date to exercise this right (European options 9 AM to 4 PM LDN; US options 9 AM to 11 AM EST)


This material is not a solicitation of any offer to buy or sell any security, commodity or other financial instrument (or related derivative) or to participate in any trading strategy. This material was not prepared by the Morgan Stanley research department. Please refer to important information and qualifications at the end of this material

12

Typical SPREAD Options Run (iTraxx Main )

Source: Morgan Stanley, Bloomberg

• Most indices (CDX IG, iTraxx Main and XOver, SOVX, MCDX) are quoted on a spread basis

Index level at which option is delta exchanged

Strike (spread)

Expiration Month Underlying

Premium (Bid) in bps

upfront

Premium (Offer) in

bps upfront

Spread Volatility

Option type: PAY (Payer) or RCV (Receiver)


13

Typical PRICE Options Run (CDX HY)

Source: Morgan Stanley. Bloomberg

• CDX HY Index is quoted on a price basisIndex level (price and equivalent running

spread) at which option is delta exchanged

Strike (price)

Expiration Month Underlying

Premium (Bid) in bps

upfront

Premium (Offer) in

bps upfront

Price Volatility

Option type: PAY (Payer) or RCV (Receiver)

Delta


14

What Happens If There Is a Default?

Index Options

• If there were a credit event in a constituent of the underlying index prior to option expiry, no action would need to be taken until expiration date

• At expiry, the option buyer will base the exercise decision on the index spread and loss expectationfrom the defaulted credit/s

• If the credit event ISDA auction settlement takes place

− after expiration date, the option exercises normally since index spread level would embed the expected future loss. In case that the option were exercised, the credit event would be settled at the auction taking place after expiration date

− before expiration date, the index protection is on the remaining names in the index, and the defaulted name is settled at the auction protocol price



15

What Happens If There Is a Default? (Cont)

Worked example of a credit event that settles after expiration date

• Investor buys in December 2010 a €100mm notional 130 strike payer option with an expiry on March 16, 2011

• Credit ABC defaults, and settles via the auction process at 40% recovery in February 2011

• At option expiry, there will be a 124-name iTraxx Main index (known as version 2)

• Investor will enter into a trade to buy protection on the iTraxx Main version 2 index at 130bps and will also receive $480,000 from the protection on the defaulted credit (100mm /125 = 800,000 per name; 800,000 * (1-40% recovery) = 480,000 loss)

• To calculate new breakeven, divide the additional payout of 0.48% of the notional by the duration (of version 2 index) to get adjusted strike price (0.48% / 4.8 = 10bps)

• Thus it would still be economical to exercise the 130 strike payer if the version 2 of iTraxxMain index were trading wider than 120bps in this case



16

What Happens If There Is a Default? (Cont)

Single-Name Options

• Single-name CDS options include a knock-out clause: if a credit event takes place prior to expiry, the option is cancelled

• A buyer of a payer option, for instance, cannot exercise it, but can buy short-dated CDS to hedge default risk

Credit Events on single name are very significant



Pricing Tools and Greeks

18

Pricing Tools: CDSO on Bloomberg

Note: This is a basic option model and these prices may not exactly match dealer prices due to differences in curve shape and difference in loss expectation before expiry etc.


Underlying Index Reference Level

Delta

Gamma

Vega

Theta

Strike

Expiry date

Notional

Volatility

Upfront premium

MtM


19

Measuring Option Risk: The GreeksCredit Options uses same “Greeks” as in options on o ther asset classes

• Delta: Delta is the ratio of the change in the price of the option to that of the market value of the underlying index. There are several metrics: dv01, dv10%, etc

• Gamma (convexity): Gamma, or spread convexity, is the change in delta for a 1bp change in the CDS curve. Also 10 bps and X% move are used to determine gamma

• Vega: Vega is the change in the value of the option for a 1% change in volatility.

• Theta (time-decay): Theta, or time decay, is the change in value of the option one day closer to expiry.

• Other: It is useful to run scenarios of how valuation and Greeks wouldtheoretically evolve in different spread scenarios



20

Credit Spread Volatility Intuition

• Implied spread volatility tells us how much the daily index move is expected to be over the period specified

− XOver June ATM implied volatility is 38%, with index spread at 353bps

− This means that annualized volatility on the index is 38%, which would be equivalent to a daily implied volatility of about 2.4% (38% / SQRT (252) )

− This is equivalent to a daily spread move of 8.5bps (2.4% x 353bps)

Daily Spread Moves: iTraxx XOver (1) (2)

Daily Spread Moves for XOver (bp)

Source: Morgan Stanley, May 2011(1) Daily spread moves in bps.(2) 8.5bp = 1σ of implied daily moves for XOver on May 2011


Daily Spread Moves for XOver (bp)

-84

-63

-42

-21

0

21

42

63

84

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11

21

Spread Volatility vs. Price Volatility

• Credit spread volatility seen on traders’ runs is NOT directly comparable to equity / FX volatility

• Credit spread volatility seen on trader quotes has to be converted to price volatility as one would do in the rates world

• A daily spread move of 8.5bps discussed in the previous slide translates into a standard deviation of daily price moves of about 0.34% (8.5bps times an approximate duration of 4.0)

• This is equivalent to an annualized price volatility of 5.4%% (0.34% x SQRT ( 252) )

• Current indicative annualized price volatility based on ATM options are

− iTraxx Main 2.0% - Equity (S&P100) 15.1%

− XOver 5.4% - FX (EURUSD) 13.1%

− Itraxx Fin Snr 3.6%

− Sovx 4.6%

− CDX IG 1.6%

Source: Morgan Stanley, May 2011This material is not a solicitation of any offer to buy or sell any security, commodity or other financial instrument (or related derivative) or to participate in any trading strategy. This material was not prepared by the Morgan Stanley research department. Please refer to important information and qualifications at the end of this material


iTraxx Main Price VolatilityiTraxx Main Price volatility at pre-crisis levels

Implied and 3m Realized VolatilityiTraxx Main

Note: Past performance might not be indicative of future performanceSource: Morgan Stanley, May 2011


iTraxx XOver Price VolatilityiTraxx XOver Price volatility also at pre-crisis leve ls

Note: Past performance might not be indicative of future performance

Implied and 3m Realized VolatilityiTraxx XOver


24

Volatility Skew in CreditCredit Options Skew is Extreme today reflecting dem and for tail hedges

iTraxx SkewStrike 80-130 Skew

Credit Options Skew

• Asymmetric nature of credit (limited upside and significant downside) makes payers far more popular than receivers, more so than in other asset classes

• That is, puts are more valuable as spread convexity and volatility exposure work in the same direction. OTM options often trade at 5% – 10% higher vol. than ATM options

• However, at very wide index spreads, spread volatility may decline as price volatility rises if wider index despite no change in spread volatility


-5%

0%

5%

10%

15%

20%

25%

Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11

Option Strategies

26

Why Trade Options?

• Hedging and risk management− The primary motivation for majority of new investors− The capped downside profile is quite valuable for many investors− Plenty of convex instruments in credit today – options can add or mitigate convexity risk− Example: buy a OTM payer hedging against a widening environment

• Income Generation− Investor sells options to increase yield – can work well in particular where investor has specific

spread targets/spread ranges in mind to take profit− Example: sell OTM receivers against a long credit portfolio

• Express directional views, with cheaper cost, better leverage and/or lesser downside− Example: Buy or sell payers/receivers outright or in combinations to take directional bets with pre-

specified upside and/or downside. Leverage and skewed risk/reward

• Volatility views− While many investors use options as an overlay on portfolios, a culture of trading volatility is

also developing − Example: Buy or sell options against index-delta to position a bullish or bearish view on spread

volatility, implement ‘carry’ strategies common in other asset classes


Note: Options are highly levered instruments which exhibit a significant downside in case of negative scenarios. Investors should be aware of the risks of such instruments.

27

Trade Idea 1: Hedging with a Payer Spread Collar on ITraxx Main

• Payer Spread Collars (PSC) take advantage of today’s steep skew and reduce hedging costs in a range-bound environment.

• Payer Spread Collars are popular because you effectively pay for the hedge only if there is a rally, when your core portfolio is also performing.

• Even in the scenario, spreads do tighten, this strategy outperforms being short the index outright.

• Payer Spread Collars (PSC) typically have the cheapest cost of basic hedging strategies. In particular, the cost advantage vis-à-vis an index hedge is substantial in a range-bound environment.


(150)

(100)

(50)

0

50

100

150

70 80 90 100 110 120 130 140 150

Sell 1 iTraxx Main Sep-11 @ 85 ReceiverBuy 1 iTraxx Main Sep-11 @ 105 PayerSell 1 iTraxx Main Sep-11 @ 130 PayerNet Position

Max P&L of 91bp

Costs -19bp if index is between 85 and 105 at expiry

iTraxx Main Payer Spread CollarPayoff profile at expiry


28

Trade Idea 2: Upside plays in CDX IG

• Vol declines, steep curves and skew AND the absence of tail risks like in Europe makes receivers attractive in the US now.

• One potential motivation for buying receivers is the existence of steep credit curves. Indeed, even as credit remains a carry trade, steep curves could lead to significant rolldown.

• The bullish risk reversal is short an OTM payer, and the key risk to this trade is a sharp widening along with a volatility spike.


CDX IG Main Payer Spread CollarPayoff profile at expiry


(100)

(50)

-

50

100

60 70 80 90 100 110 120 130 140 150

Buy 1 CDX IG Sep-11 @ 80 Receiver

Sell 1 CDX IG Sep-11 @ 130 Payer

Net Position

29

MS Web Tool




Disclaimer

IMPORTANT INFORMATION: This information has been prepared solely for information purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy. This information is confidential and is solely for your internal use. This information is based on or derived from information generally available to the public from sources believed to be reliable. No representation or warranty can be given with respect to the accuracy or completeness of the information, or with respect to the terms of any future offer of transactions conforming to the terms hereof. We do not undertake to update this information. Certain assumptions may have been made in the analysis that resulted in any information and returns/results detailed herein. No representation is made that any results/returns indicated would be achieved or that all assumptions in achieving these returns have been considered or stated. Changes to the assumptions may have a material impact on any results/returns detailed. Morgan Stanley & Co. International plc and its affiliates disclaim any and all liability relating to this information, including without limitation any express or implied representations or warranties for statements contained in, and omissions from, this information. Additional information is available on request. Morgan Stanley & Co. International plc and others associated with it may deal as principal in or own or act as market maker for securities and instruments mentioned herein or of issuers mentioned herein and may also advise or seek to advise issuers of such securities and instruments. Where you provide us with information relating to a customer order or proposed transaction, we may use that information to facilitate the execution of your order or transaction, in managing our market making, other client facilitation activities or otherwise in carrying out our legitimate business (which may include, but is not limited to, hedging a risk or otherwise limiting the risks to which we are exposed). Where we commit our capital in relation to either ongoing management of inventories used to facilitate clients, or in relation to providing you with quotes we may make use of that information to enter into transactions that subsequently enable us to facilitate clients on terms that are competitive in the prevailing market conditions. Past performance is not necessarily indicative of future results. Price and availability are subject to change without notice. Morgan Stanley does not give investment, tax, accounting and legal or regulatory advice and prospective investors should consult with their professional advisors. Unless indicated, these views are the author's and may differ from those of Morgan Stanley research analysts or others in the Firm. This communication is a marketing communication; it is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. Unless stated otherwise, the material contained herein has not been based on a consideration of any individual client circumstances and as such should not be considered to be a personal recommendation. This communication is directed at sophisticated prospective investors in order to assist them in determining whether they have an interest in the types of security described herein. In the UK it is directed only to those persons who are eligible counterparties or professional clients and must not be acted on or relied upon by retail clients (each as defined in the UK Financial Services Authority's rules).


Risk Factors

Options are not for everyone. Before purchasing or writing options, investors should understand the nature and extent of their rights and obligations and be aware of the risks involved, including the risks pertaining to the business and financial condition of the issuer and the underlying instrument. A secondary market may not exist for certain of these instruments. For Morgan Stanley customers who are purchasing or writing exchange-traded options, please review the publication ‘Characteristics and Risks of Standardized Options,’ which is available from your account representative.

The transaction(s) described in this presentation involve a number of risks. This presentation highlights a limited number of those risks but does not purport to be a complete list of the risks inherent in the transaction(s). Investors should ensure they review the final offering/transaction documents and consider all relevant risks prior to making an investment decision. You must determine the suitability of any transaction restructuring proposal in light of your own circumstances. In particular, you should:

(a) have sufficient knowledge and experience to make a meaningful evaluation of any transaction, the merits and risks of investing in such transaction and the information contained or incorporated by reference in the final offering memorandum or any applicable supplement or final transaction documents; (b) have access to, and knowledge of, appropriate analytical tools to evaluate, in the context of the particular financial situation, any transaction and the impact such transaction will have on your overall investment portfolio and performance; (c) have sufficient financial resources and liquidity to bear all the risks of any transaction; (d) understand thoroughly the terms of the transaction; and (e) be able to evaluate (either alone or with the help of a financial advisor) possible scenarios for economic, interest rate and other factors that may affect your investment and your ability to bear the applicable risks.

Independent Advice: prospective investors should make their own independent decision to enter into the transaction and as to whether the transaction is appropriate and proper for them based on upon their own judgment and upon advice from such advisors as they deem necessary. Prospective investors should consult (and continue to consult) with their own legal, regulatory, tax, business, financial, investment, accounting and regulatory capital advisers as well as such other advisers as they deems necessary. Further, in making an investment decision, prospective investors should not rely on any advice, counsel or representations (whether oral or in writing) of Morgan Stanley & Co. International plc or any of its affiliates or associates (the “Morgan Stanley Group”). No communication (written or oral) received from these entities will be deemed to be an assurance or guarantee as to the expected results of any transaction mentioned in this presentation. This document is not a recommendation to enter into any transaction and is not intended as any form of investment advice and should not be relied upon as such. The Morgan Stanley Group is not acting as a fiduciary for or an advisor to prospective investors in respect of any transaction(s) or strategies described in this presentation. There can be no guarantee that the transaction(s) described in this presentation will meet its objectives.

Full Service Securities Firm: The Morgan Stanley Group is a full service securities firm engaged in securities trading and brokerage activities, as well as providing investment banking and financial advisory services. In the ordinary course of its business, the Morgan Stanley Group may, from time to time, (i) be in possession of non-public information that will not be disclosed to prospective investors; and (ii) may at any time hold long or short positions in, and may trade or otherwise effect transactions in, for its own account or the account of customers, debt or equity securities or instruments (A) issued by any other company that may be involved in transactions that are related to any transaction(s) described herein; (B) owned by potential investors or that are substantially similar to securities or instruments owned by potential investors; (C) that may be purchased by potential investors; or (D) the trading of which may affect investments made by potential investors.

Tax, Accounting and Regulatory Considerations: Special tax, accounting and regulatory considerations may apply to certain types of investors. Prior to making a decision to enter into any transaction(s), prospective investors should consult with their tax, accounting and regulatory advisors. The Morgan Stanley Group does not give tax, accounting or regulatory advice.

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