Credit swaptions, that is, options on credit default swaps, have been traded on a fairly regular basis since shortly after the creation of the standard credit derivative indices. Credit swaptions allow traders to take a view on the volatility as well as the direction of credit spreads.
Though widely regarded as a natural part of the credit derivatives toolkit, credit options have never achieved the same volumes as other second-generation credit derivatives such as index tranches. One reason for the underdeveloped state of this market is that the rolling nature of the indices makes it difficult for dealers to make a market in swaptions dated longer than nine months. This is because the liquidity of an index dries up shortly after a new series is issued.
Liquidity of the underlying instrument is essential for options because dealers need to delta-hedge their options with the underlying instruments regularly to reduce the risk in their trading books. Swaptions on single name credit default swaps have seen less trading than index swaptions, given the greater liquidity of indices compared to single name credit default swaps.
Two types of credit swaptions are traded equivalent to the call and put options traded on cash instruments. Receiver swaptions give the option buyer the right to receive premium, that is, to sell protection, on a certain date at a certain price (called the ‘strike’). Payer swaptions give the option holder the right to pay premium, that is, to buy protection, on a certain date at a certain price. This terminology is the same as that used in the interest rate swap option market where the premium on the credit default swap is the equivalent to the fixed leg of the interest rate swap.
While other asset classes see various different types of options traded, such as American, European, Bermudian and Asian options, the credit swaption market primarily trades in the form of European options. This means the option buyer can exercise its option to enter into a credit default swap with the option seller only on the maturity date of the option (called the option expiry date).
The most liquid swaptions are those with strikes that are at-the-money, that is, where the exercise price is the same as the forward price of the credit default swap at the expiry date on the day of the trade.
A big difference between credit swaptions and options in other markets is that single name credit swaptions trade with a ‘knock-out’ feature. (This feature does not apply to index swaptions.) This simply means that if there is a credit event on the underlying credit, the option contract terminates worthless. In other words, the buyer of a payer swaption is not protected against credit events prior to exercise.
The knock-out feature means that dealers are often unwilling to price swaptions on credits with high spreads. A payer on a credit that is near to default would typically have one of two opposite outcomes – the name survives and the option is worth a great deal or the credit defaults and the option knocks out and becomes worthless. This makes it hard to value and hedge swaptions.