Anatomy of a Cross- Asset Trade: Credit vs. Equity 2008 Chicago Board Options Exchange®, Incorporated. All rights reserved. Presented by: Matt McFarland, Director – Credit Derivatives, CBOE June, 2008
Anatomy of a Cross-Asset Trade: Credit vs.
Equity
2008 Chicago Board Options Exchange®, Incorporated. All rights reserved.
Presented by: Matt McFarland, Director – Credit Derivatives, CBOE
June, 2008
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Disclosures
Options involve risk and are not suitable for all investors. Prior to buying or selling anoption, a person must receive a copy of Characteristics and Risks of Standardized Options(the “ODD”). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS,or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago,Illinois 60606. The information in this presentation is provided solely for general educationand information purposes. No statement within this presentation should be construed as arecommendation to buy or sell a security or to provide investment advice. Any strategiesdiscussed, including examples using actual securities and price data, are strictly forillustrative and educational purposes. In order to simplify the computations, commissions,fees, margin interest and taxes have not been included in the examples used in thispresentation. These costs will impact the outcome of all stock and options transactions andmust be considered prior to entering into any transactions. Investors should consult their taxmust be considered prior to entering into any transactions. Investors should consult their taxadvisor about any potential tax consequences. Past performance is not indicative of futureresults. CBOE® and Chicago Board Options Exchange® are registered trademarks andCEBOs is a servicemark of CBOE. All other trademarks and servicemarks are the propertyof their respective owners.
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Agenda
Credit / equity correlation
The Homebuilding Sector Are the credit and equity markets telling the same story?
Credit Event Binary Options
Constructing a trade
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Constructing a trade Profit & Loss
Risks to the trade
Margin considerations
Conclusions / Q & A
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Credit / Equity Correlation
VIX vs Credit Spreads since 2003
800
1000
25
30
35
40S&P Speculative Grade Credit Spread
VIX
4
Sources: CBOE and Standard & Poor’s
0
200
400
600
1/10/2003 1/10/2004 1/10/2005 1/10/2006 1/10/2007 1/10/2008
Cre
dit
Sp
rea
ds
0
5
10
15
20
25
VIX
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Homebuilding Sector: XHB
5
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
BBR: Homebuilder Sector CEBO expiring in Sep.2008
6
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
XHB components
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Similarities: BBR CEBO & XHB deep OTM put
Both are securities, traded in a securities account
Both should increase in value as equity prices / creditquality decline
It takes extreme events / movement for either to go‘in-the-money’
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‘in-the-money’
Same expiration (September 2008)
Same sector, subject to the same fundamental news
Maximum gain and maximum loss is known for both
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Differences: BBR CEBO & XHB deep OTM put
XHB – 23 components; BBR – 8 components
XHB – equity derivative; BBR – credit derivative
XHB put – 100 multiplier; BBR – 1,000 multiplier
Different margin requirements
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Which XHB deep OTM September put should wetrade?
At a trade price of $3.00, CEBO implies a 5%chance of 8 credit events
$3,000/$60,000 = 0.05
Which XHB put implies a 5% chance ofdisaster within the sector?
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disaster within the sector?
5 delta put on Sep XHB = 13.0 strike XHB Sep. 13.0 put value on May 19 = $0.25 with XHB
trading $22.00
To get ~$60,000 worth of exposure = 46 contracts
$1,150
$1,850 more premium in CEBOs
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
What is the market telling us?
Demand for credit protection on homebuilders isgreater than demand for equity protection CEBOs appear rich relative to equity options, considering
this example’s view that homebuilders will remain solvent forthe next several months
Hypothetical Trade on 5/19/08: Buy 46 XHB Sep. 13.0 puts
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Hypothetical Trade on 5/19/08: Buy 46 XHB Sep. 13.0 putsfor $0.25 / Sell 1 Sep. BBR CEBO at $3.00
Debit for the puts = $1,150
Credit for short CEBO = $3,000
Net credit = $1,850
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
XHB, BBR, & Sep. 13.0 put
XHB, BBR, & Sep. 13.0 puts
25
30
35
40
12
0
5
10
15
20
3/2
8/0
7
4/1
9/0
7
5/1
0/0
7
6/1
/07
6/2
2/0
7
7/1
6/0
7
8/6
/07
8/2
7/0
7
9/1
8/0
7
10/9
/07
10/3
0/0
7
11/2
0/0
7
12/1
2/0
7
1/4
/08
1/2
8/0
8
2/1
9/0
8
3/1
1/0
8
4/2
/08
4/2
3/0
8
5/1
4/0
8
XHB BBR Sep. 13.0 put
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Zero Credit Events: P&L at expiration
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
1 credit event: HOV defaults 6/15/08,Value at expiration
14
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
8 credit events: value at expiration with XHB at$4.00
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
What about all of the possibilities in between?
XHB should fall
Implied volatility should increase XHB Sep. 13.0 put increases
Time decay
Credit spreads should widen, thereby increasing the
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Credit spreads should widen, thereby increasing theprice of the CEBO
But there will also be downward pressure on theCEBO due to less components and time decay
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Coupon payment dates (no principal due)
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Key fundamental dates
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Which BBR component is most likely to default,according to the market?
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Margin considerations (Exchange minimums)
Customer Long XHB Sep. 13 puts
Premium paid in full ($1,150)
Short CEBO Max. cash settlement amount + premium received ($63,000)
Qualified Customer ($5 million)
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Qualified Customer ($5 million) Long XHB Sep. 13 puts
Premium paid in full ($1,150)
Short CEBO 15% of the max. cash settlement amount + premium received
($12,000)
Broker-Dealer SEC’s Net Capital Rule provides offsets when short CEBO is
combined with a long equity put position
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
CBOE’s Credit Options Complex
Single Name CEBOs Ford Motor Co. (FDE)
General Motors Corp. (GCB)
Hovnanian Enterprises (CKA)
Standard Pacific Corp. (JSV)
Basket CEBOs
Auto Sector (AYF)
Homebuilder Sector (BBR)
High-Yield Composite (HAU)
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Standard Pacific Corp. (JSV)
Each CEBO currently has two expirations September 2008
September 2012
More CEBOs with more expirations will be listed
Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Conclusions
Credit vs. equity trades may present profitabletrading opportunities
CBOE’s Credit Event Binary Options allow all investorsthe opportunity to trade credit derivatives
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Anatomy of a Cross-Asset Trade: Credit vs. Equity June 2008
Where to learn more about CBOE’s CreditDerivatives
www.cboe.com/credit
Matt McFarland – Director, CreditDerivatives
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Derivatives
312-786-7978