Cross-Asset Trades: Equity Vol vs Credit

Investors may wish to consider trading VS against CDS to exploit discrepancies between equity and credit markets.

Both VS and CDS give some measure of risk associated with a particular company, and should be correlated.

Index variance vs credit

Credit and equity have a very strong relationship over the LT.

However, there are several instances where ST opportunities have arisen in one of the asset classes, and where the other asset could have been used as a hedge against a wider macro economic change in regime.

May 2005: credit markets sold-off.

- particularly noticeable in US --> not really reflected in a commensurate increase in SPX IV

--> long equity vol against long credit position --> hedge to possible macro deterioration.

May 2006: equity volatility spiking while credit markets remained unmoved.

--> long CDS/ short equity vol to take advantage of price dislocation while some degree of protection for a more macro change in regime.

Counter-intuitively 5y CDS levels are more correlated with short-dated variance than with longer-dated variance.

It is probably due to benchmark effects:

- short-dated VS are the most liquid ones

- longer-dated VS more susceptible to structured product flows

Single stock variance swaps and debt/equity

Indices can provide ST opportunities to trade credit vs equity variance --> suffer from basis risk from index members.

This can be important in credit indices which may be driven by idiosyncratic default events by single companies.

Probably the majority of debt/equity trading is focussed on single name capital structure analysis.

--> attempt to model the relationship of company's share price to price of its credit and equity options.

Typical trade to take advantage of debt/equity mispricing --> combination of equity puts vs CDS.

One of the main deficiencies --> share price is non-stationary, compared to CDS which is more mean-reverting.

Example:

Fig. 89: Fiat CDS as a function of share price

Pre-2004 --> CDS tended to widen when share price fell to €15.

More recently --> it has taken a much lower share price (< €10) to increase CDS.

--> Leverage reduction has reduced the price at which the credit market assumes that the company will become distressed.

A simple regression model would assume that CDS behaved like a €15 put option and a combined trade using this strike put against CDS would not correctly model the capital structure.

Fig. 90: because IV factors in some of this reduced risk, the relation between Fiat IV and credit is more stationary.

Hence, variance swaps can be useful instruments as vehicles for expressing a view on the capital structure of a company.

In practice, some combination of variance and the underlying equity may be used.

Single vs vs credit