Citigroup has launched a credit equivalent of Wall Street’s “fear gauge” that is intended to provide an accurate metric for risk aversion in the asset class.
Citi’s “credit VIX” mirrors the CBOE’s VIX methodology, using a weighted average of option prices on credit default swap indices across a range of strikes.
The new index, which tracks implied volatility across investment-grade and high-yield CDS indices in the US and Europe, was developed in response to rising interest in the VIX as it plummeted to its lowest level in a quarter of a century last week.
“We replicated this methodology to create a ‘credit VIX’, which we think captures a lot more information contained within option markets, allowing it to serve as a more accurate metric for broad risk aversion, and one which we think investors should track going forward,” said Aritra Banerjee, a credit analyst at Citigroup.
As one of the fastest growing instruments for bank credit desks, CDS index options have become popular among investors to hedge credit tail events. Given the high demand is for downside protection, a steep skew - the difference between at-the-money and out-of the-money strikes - would be ignored by traditional risk barometers.
“At present we usually look at things like at-the-money implied volatility or payer skew to ascertain the level of risk being priced in credit markets,” said Banerjee. “However, looking at just one point misses useful information contained elsewhere in option prices.”
According to Banerjee, clients are already keen to trade instruments linked to the benchmark, enabling them to trade pure credit variance in a single transaction.
The liquidity profile of the credit options market could prove to be a hurdle in the short term, Banerjee said. To trade such instruments, a bank must recreate the credit VIX by buying and selling options in very specific sizes across the full spectrum, where there may not always be the liquidity to hedge exposure perfectly.
“We think more work needs to go into the effective pricing and hedging of such products, as well as for more standardisation of market-wide conventions,” said Banerjee.
Those developments would include central clearing of credit options and standardisation of option expiry fixings.
TRADABLE BENCHMARK
Citi is not alone in its endeavours. JP Morgan has already traded swaps linked to its own credit version of the VIX that launched in late 2015. The VTRAC-X family of CDS volatility trackers is similar to Citi’s latest iteration and priced off a basket of weighted option prices across all traded strikes for any given expiry.
Although volume has been low to-date, a JPM spokesperson confirmed rising interest across products that give investors access to credit volatility.
The VTRAC-X benchmarks are quoted in price rather than spread, similar to the VIX and reflecting the quoting convention of Markit’s CDX HY. According to JPM analysts, the focus on price addresses concerns that a simple application of VIX methodology to credit options quoted on a spread basis would not accurately reflect the actual level of market implied volatility.
Citi’s credit vol benchmarks are quoted in line with options market convention. They note that credit VIX tends to correlate well with CDS index spread moves, particularly in Europe. Analysis shows that spreads across various US and European credit indices show a beta of around 0.35-0.4 to moves in credit VIX.
The analysis also shows that the implied volatility environment is even more benign for credit than it is in equities.
While VIX hit 9.56 last week, credit VIX hit similar lows earlier in the year. Banerjee said that the difference is explained by structural differences between the two markets.
“The credit market is a much younger one than the deeply entrenched equity market. As a result there are fewer systematic short-volatility strategies in credit,” said Banerjee, though he said that those strategies have become more prevalent in recent months.
“Credit markets don’t have the large exchange-traded product participation which the VIX does, hence there is less pressure on option prices from various short-selling strategies.”
While the CBOE has already extended VIX to other asset classes including commodities and interest rates, credit has yet to be added, in part due to the relative youth of the credit options market and its historic correlation to the equity options market.