Bloomberg released a new analytic function for pricing of options on credit default swap indices (CDS), which allows the holder the right to enter a forward-start CDS contract to buy or sell protection, based on the market -level strike agreed upon today.
During periods of low credit activity, CDS options are providing market participants the ability to leverage volatility in a cost-effective and defined way. The Bloomberg CDSO function calculates prices and sensitivities for Options on CDS Indices, such as ITRAXX and CDX, retrievable from the CDSI database. Users can calculate either the fair option premium or the volatility implied in a given price.
“Credit option volumes grew dramatically in 2005, and we expect a continued broadening of the account base in 2006 as investors focus on the convexity profile of their portfolios, and expressing views on the likely trading range of spreads,” said Daniel Berman, head of European credit product management at JP Morgan in London. “Bloomberg’s options calculator will allow consistent and transparent pricing of the most common option formats, thereby providing a common language for client dialogue.”
The contingent leg is a flat curve with the spreads of the underlying Index but it is also customizable for upward or downward sloping CDS curves. The option volatility defaults to the historical volatility of the index over three months based on Bloomberg’s contributed data; it is supplied at 40% when data is missing. The output includes several analytics (such as forward start PV01 and ATM forward rate) and sensitivity measures (DV01, Delta, Gamma, Vega).
“The release of the CDSO page on Bloomberg allows market participants to refer to a standard options pricing tool for index credit options,” said Patrick Britt, head of options broking at Credittrade in New York. “While participants’ models can differ, the existence of CDSO should help establish a bona fide inter-bank index options market. From Credittrade’s perspective this is extremely helpful as market participants have indicated to us that they would like to see more liquidity in CDS options, and we would welcome that development.”