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Credit Options


Frequently Asked Questions (FAQ's)


  1. What is a Credit Event?
    Under CBOE's rules, three items are defined as Credit Events that can be designated to trigger a payout for CEBOs: 1) Event of Default (e.g., bankruptcy) of a company, 2) Failure-to-Pay interest or principal on its corporate debt (typically more than $750,000), and 3) Restructuring of corporate debt (e.g., lengthening the maturity or changing the coupon rate of corporate debt). CBOE can choose which Credit Events apply for CEBOS from this menu.

    CBOE initially intends to specify a single credit event for CEBOs, e.g., bankruptcy, in contrast to International Swaps and Derivatives Association (ISDA) CDS contracts which also include failure-to-pay and restructuring as Credit Events. CBOE is intentionally deviating from standard Over-The-Counter (OTC) practice to simplify, streamline, and reduce any ambiguities in defining a Credit Event. CBOE believes this simplified method increases transparency and identifies the credit risk cleanly and objectively which enhances the customer value added proposition.
  2. What is a Binary Option?
    It is an option that pays a fixed maximum notional amount ($1,000) if a Credit Event is confirmed and expires worthless ($0) if no Credit Event occurs during the contracts life.
  3. Who, When, and How can a Credit Event be Confirmed?
    CBOE determines Credit Events based on at least two information sources. These can be public news services, regulatory agencies, other exchanges, the OCC, or bankruptcy courts. To trigger a payout in a CEBO, a Credit Event must occur during the life of the option up to and including its last day of trading. CBOE has up to four days after the scheduled last trading day to confirm and announce whether a credit event has occurred.
  4. What Types of CEBOs are There?
    • Single-Names - are companies ("Reference Entities"), e.g., Bank of America (BAC), that have outstanding public debt. For CEBOs, a specific debt issue is identified as a "Reference Obligation, e.g., BAC's 5.375% June 15, 2014 corporate note, that is an example of the company's issued debt and the issue to which CBOE looks to identify what may constitute a Credit Event for the company.

      Basket-CEBOs - a Basket CEBO is a package of multiple "Reference Entities." Examples include baskets that are referenced to the debt securities of corporations in the same economic sector or broad-based baskets referenced to the debt securities of corporations of the same credit quality (e.g., investment grade). On the listing date, CBOE specifies the notional value of the basket, the components of the basket, their weights within the basket and the recovery rate for each basket component. For example, a basket could have a notional value of $1,000, contain 10 equally weighted components and each company have a specified recovery rate of 40%. A Multiple-Payout CEBO basket automatically pays a specified dollar amount each time that CBOE confirms a Credit Event in a component of the basket. The basket component is then removed from the basket and is not replaced and the contract continues to trade. If a Credit Event is confirmed in all components, the CEBO basket will stop trading. The Credit Event payout is equal to the notional value of the basket times the weight of the component that has the Credit Event times one minus its recovery rate. In the example above, the option would pay $60 ($1,000 * 0.10) after each confirmed Credit Event. Therefore, the sum of payout(s) would range from $0 to $600 depending on how many Credit Events are confirmed by CBOE over the life of the Basket CEBO.
  5. How are CEBOs quoted?
    CEBOs will be quoted in penny ($0.01) increments from a minimum tradeable price of a penny ($0.01) to a maximum tradeable price of $1.00 dollar. The contract will have a 1000 multiplier deriving a range dollar value between $0.00 and $1000. Each minimum tick value will therefore be $10.00 dollars (1000 * $0.01). At expiration, the contract will either expire worthless if not Credit Event has been confirmed or will result in a payout of $1000 (1000 * $1.00) if a Credit Event has been confirmed. As mentioned the contract will be quoted $.01 increments and expressed as 0.11, 0.12, 0.13, etc...

    Designated Primary Market Makers (DPMs) are responsible for making markets and providing liquidity for a selected number of CEBOs. Consequently, they are obligated to provide an opening quote. Conversely, CEBOs that are not assigned a DPM will trade via a Request-for-Quote (RFQ) process. Market participants will simply indicate an interest in a particular class via our CFLEX trading platform and wait for a response to be submitted. After a quote is submitted the requestor will have the option to participate or not. The requestor needs to realize that prior to the RFQ there will not be any visible quotes displayed hence the requestor initiates the process.
  6. How is the premium calculated and what does it imply?
    The CEBO's premium value is derived from the summation of discounted probabilities of a Credit Event occurring over the contract's life. The table below illustrates the 5-year. term structure and its corresponding default probabilities and discount factors. If you refer to column four "p = sub-period default probability" it lists each period's assigned probability of a Credit Event occurring from 6 months to 5 years, .0158, .0154,...0907. The summation of the individual probabilities equals .397 or 39.7%, illustrated in the second column "term structure of default probabilities" last row. Simply stated, given the set of assumptions this represents a 39.7% probability of a Credit Event occurring over the contract's life. Column Five, titled "D = discount factor" represents the prevailing interest rates converted to a present value multiple so the expected value of the outcome can be derived. This is achieved by multiplying the individual probabilities by their respected discount factor and summed, which equals a 34.17% probability of default which is equivalent to a 0.34 (rounded) option premium and is shown in the last column titled "100 * p * D", bottom row.

    A simpler approach would be to assign an equal distribution of probabilities over the term structure. When using the original 39.7% probability the discount factors will remain the same and a new CEBO valuation equaling 35% or $0.35 option premium is derived.

    Source: Bloomberg and CBOE

  7. What are some trading applications?
    Several possible trading applications of CEBOs are outlined below purely for illustrative purposes. The Exchange is not recommending or endorsing a particular investment strategy or providing investment advice, and encourages investors to consult with their broker. Single-Name CEBOs can be used for various investment strategies, including, but not limited to
    • Hedge corporate debt with CEBOs. A long CEBO position can be established against a corporate bond to offset the embedded credit risk inherent in the bond's price. Since single-name CEBOs pay a fixed dollar amount following the confirmation of a Credit Event, investors can buy CEBOs to convert corporate debt to Treasury quality by reducing the credit risk. An active portfolio manager would benefit from this type of execution strategy by efficiently managing transaction costs, avoiding the necessity to monetize unrealized gains or losses prematurely, or encountering potential liquidity risk from rebalancing their portfolio during market stress. Conversely, CEBO sellers can take on credit risk without having to buy corporate bonds. In fact, you can synthetically create a corporate bond by overlaying CEBOs onto a variable rate LIBOR interest rate strip. This strategy could possibly be implemented to capitalize on a corporate bond arbitrage opportunity.

      Source: Bloomberg and CBOE

    • Hedge equities with CEBOs. As illustrated below for AMR, there is a significant inverse correlation between put volatility and share price. As evidenced by the graph, an alternative hedge to protect against adverse equity movements may exist with CEBOs, since such a high positive correlation exists with put volatility.

      Source: Bloomberg and CBOE

    • Hedge Deep-Out-Of-Money (DOOM) equity puts with CEBOs. DOOMs are self explanatory however, what may not be so apparent are their high correlations between Credit Default Swaps (CDS) and CEBOs (See Hovnanian HOV chart below). DOOM options track CDS spreads and CEBOs closely, especially in times of severe credit deterioration, the moments when credit protection is most necessary. DOOMs, CDSs, and CEBOs track well because they all contain components that measure investor sentiment. DOOMs provide an effective relative value pricing mechanism for CEBOs and offer a potential capital structure arbitrage opportunity between the equity and credit tranches. For additional information please refer to www.cboe.com/doom too see all the single-name DOOMs that correspond with each CEBO.

      Source: Bloomberg and CBOE

    • Hedge fixed-recovery OTC CDS spreads with CEBOs. These asset classes should have a close relation to each other since the recovery rate is predetermined and the differences between the two are primarily limited to the amortization of the option premium and suspension of the coupon payment after the confirmation of a Credit Event.

      Source: Bloomberg and CBOE

  8. Why would a market participant want to trade credit derivatives on an equity derivatives exchange?
    CBOE views credit derivatives as a natural extension of our equity options business. Equity option premiums reflect changes to the credit ratings of the underlying security. For example, put values should increase on concerns that the underlying entity will declare bankruptcy. In practice, there currently exist numerous institutions that trade equity options versus credit derivative products. Our new product line will enable these traders and many others to access equity options and credit options through the same channels.

    Source: Bloomberg and CBOE

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