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Though credit-default swap index options have been around for a few years, investor interest, liquidity and volumes have increased significantly only this year.
Though credit-default swap index options have been around for a few years, investor interest, liquidity and volumes have increased significantly only this year. This growth is partly attributable to increased liquidity of the underlying CDS index market that has reduced the cost of hedging options and standardization of the CDS index option market through introduction of ISDA documentation. The accounts involved have included real-money managers, hedge funds and proprietary trading desks. In North America, traded CDS index options are on the Dow Jones CDX set of indices: CDX Investment Grade (CDX.NA.IG: comprised of 125 names), CDX High Volatility (CDX.NA.HVOL: 30 names), CDX Crossover (CDX.NA.XO: 35 names), and CDX High-Yield (CDX.NA.HY: 100 names). In Europe, traded CDS index options are on the iTraxx Europe set of indices: iTraxx Europe (125 names), iTraxx HiVol (30 names), and iTraxx Crossover (45 names).
Mechanics
Two types of CDS index options trade: payers and receivers. All CDS index options are European style, i.e. they can only be exercised on the expiry date. A payer option holder has the right but not the obligation to buy protection on the underlying index at the strike spread level on expiry. Similarly, a receiver option holder has the right to sell protection at the strike spread level. At any time, options with expirations on the next two to three CDS market roll dates (December 20, March 20, June 20, September 20, or next business day) are most liquid. Other expirations are also common and options with up to one-year tenor have traded in the market. The underlying index is usually the on-the-run five-year index...