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Part - IV

To appeal to investors in the current tight-spread environment, dealers have concentrated much of their R&D on yield-enhancing products and strategies. "We are seeing increased interest in yield-enhancing products that can, say, provide the return of a non-investment grade product at a lower level of risk," says Gregg Whittaker, global head of credit derivatives at Chase Securities. The movement toward synthetic structures-perhaps kicked off by JP Morgan's $594 million note linked to the credit of Wal-Mart stores last August and Chase's subsequent issuance of securities based on a portfolio of non-investment-grade loans called the Chase Secured Loan Note Trust (see Derivatives Strategy, December-January, page 20)-has continued as spreads remain lackluster.

The tight spreads have also increased investor interest in straight arbitrage deals. Basically, this entails taking advantage of the differences in how credit is priced within a company's capital structure. For example, if you think that Company A's credit is worth more in the bond market than it is in the corporate loan market, then you can use credit derivatives to maintain a long position in "bond" credit and a short position in "loan" credit. CIBC's Rai says that his firm has developed proprietary models in order to identify irrational differences in credit pricing.

Tad Lundborg, serior vice president in credit derivatives at Tullet & Tokyo Forex in New York, notes that, in the future, credit spread options may gain in popularity because they can give end-users protection in the event of substantial unfavorable credit migrations short of default. "If, for example, a reference credit moves from single A to double B, spreads will move to reflect this change," he says. "End-users who have purchased spread options will be able cash in-even though the reference credit hasn't actually defaulted."

New arguments for using credit derivatives are appearing monthly. Large dealers are also looking at how credit derivatives can benefit their internal operations. According to Phillip Borg, head of global credit derivatives at Bankers Trust, dealers can exploit a number of synergies between credit derivatives and the cash markets. "Although asset swaps, for example, can be hedged using default swaps, this is only going to happen when there is good communication between the credit derivatives and asset swap groups, or when they are part of the same business line," he says. "These synergies exist throughout the debt industry. That's why credit derivatives at BT is in the same business line as the underlying cash businesses." Other dealers have positioned credit derivatives groups in the same fashion.

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* Contributed by -
Prashant Jadhav,
2nd Year PGeMBA (Finance),
Mumbai Educational Trust (MET) Schools of Management, Mumbai.