Alternative Market Perspectives with Issuer Volatility Risk™

A recent MSCI research blog, “CDS HEDGING: EXPLORING ALL THE OPTIONS” (1/23/2018), pointed out that the decline in single name CDS trading has also led to a decline in the quality of credit spread information published by dealers. The plot below from that same research demonstrates this challenge to transparency in credit market data with the case of Cisco (CSCO).

Figure 1 - CISCO CDS SPREADS HAVE NOT REACTED TO RECENT CREDIT MARKET DOWNTURNS (Source: MSCI, Markit)

 

MSCI recommends looking at corporate bond spreads to improve the estimate of credit spreads, especially where it becomes clear that the CDS has lost correlation with the appropriate index product. The challenge with bond spreads, however, is that each bond has security specific characteristics such as liquidity, and collateral conditions (e.g., hard-to-borrow) that can skew the credit spread picture. This, in fact, was one of the original attractions of using the more “pure” CDS data.

This circumstance highlights the value of having alternative market perspectives on credit spreads. The plot below demonstrates the equity derivatives market view of CSCO spreads, using the Hanweck Issuer Volatility Risk (IVR™) analytics to create a synthetic credit spread.

 


Figure 2 - CISCO CDS SPREAD (Bloomberg) is less reactive than Hanweck IVR (Source: MSCI, Markit)

 

IVR is entirely sourced from exchange traded equity derivatives, and yet generates a view of credit risk in CSCO that is more similar to CSCO bond spreads and CDX than the comparatively unresponsive CDS series (Figure 2). IVR shows variations including the spread spikes in 2016 visible in the CDX and bond series in the first plot (Figure 1). IVR data can be a valuable complement to traditional sources of credit spread data.

Hanweck generates a cross-asset class view of credit with the Issuer Volatility Risk analytic. We generate an implied probability of default for all US equities with listed options. IVR uses models that support a price evolution process that unlike say Black-Scholes, allow prices to hit a default barrier including price=0. The result is an equity derivative implied probability of default can further be expressed as a credit spread given certain assumptions such as a recovery rate. Although spreads vary relative to other measures directly from the Fixed Income market, the difference tends to be mean reverting, making it valuable for monitoring credit spreads. Unusual changes in the spread can be especially interesting, where either the equity market or credit market may be first in detecting new information that may affect the perceived credit of a name. Hanweck has histories available such as over 10 years of Russell 1000 universe and generates updates from intraday to daily frequencies.

 

Robert Levy

Head of Business Development

rlevy@hanweck.com