out of the money tranches on CDX and iTraxx indicies

[shanlane]

Hello,

What exactly is meant by an "out of the money tranche on CDX and iTraxx indcies"?
I know what the two indicies are, I know what a tranche is and I know what out-of-the-money means, but an "out of the money tranche on a CDS index" does not make much intuitive sense.

Then you say that if there is a "significant systemic risk" they will be priced below value. In this case, wouldn't they sell for a higher value because the probability of a payoff would be higher?

Am I looking at something backwards?

Thanks!

Shannon

 

[ibrahim-1987]

hi shannon,

as y know, this is a way to hedge agaisnt tail risk, but before answering yr q, let me do some breif explanation:
y wanna hedge against tail risk, & tail risk means a high volatility situation. ( by the way, i'm totally convinced that tail risk won't happen idiosyncraticlly, when it happen it will be systematic)

again tail risk means a high volatilty condition, and y want to protect yr self from it, BY offsetting yr losses from tail risk, & y do that by, Buying OTM option on CDX or iTraxx.

OTM option on CDX, means y will be paid by the writer IF volatility becomes high ( Tail Risk). so it is now OTM because volatility is low, but if tail risk happened, it will be ITM.

it works like catastophe Bond, that insurance companies issue.

 

[shanlane]

Thank you, that makes complete sense except for one thing: the part about the tranche being priced below value if there is significant systemtic risk. If there is significant risk, wouldn't the cat bond be more expensive because the liklihood of a payoff is higher?

Thanks!

Shannon

 

[ibrahim-1987]

I'm sorry Shannon, but let me correct something,
Cat band is issued by the corporate that want to protect it self from cat, & if cata occurs, the corp will stop paying interest and principal, so y have to look at it from the other perspective.

In short, it will be undervalue to convince investors to buy it.

 

[shanlane]

I think its a bit different than that, because a cat bond is almost like a credit linked note in that the protection is funded. Of course you would have to sell it at a discount. Maybe I a missing (or implying) a cause/effect relationship that does not exist.

I was reading this as saying when there is systematic risk, the prices on the lower tranches will decrease (will be priced below value). If instead this means that IF the prices stays the same as the systemtic risk grows, then I completely agree that they would be undervalued.

Does this sound right?

Thanks!

Shannon

 

[ibrahim-1987]

hi shannon,
first take a look at this link: http://www.investopedia.com/terms/c/catastrophebond.asp#axzz1tDjxwwY1, or review : VaR approach to operational risk , in L1, T4.

Cat bond will be priced at discount, IF and only IF, systematic risk happened or about to happen. but this assumption is only theoratical, because if systematic risk happen, then Cat bond will stop paying interest and principal, then , what kind of invetors who will buy a security that will not even pay the principal!!!! it is extremelly irrationally.

Cat bonds, are fairly priced in ordinary situations, BUT it will be Underpriced if INVETORS holding cat bonds feel that systematic risk will be high soon, so they will try to get rid of it by selling it at discount.

 

[shanlane]

I am not sure if your explanation about Cat bond is correct. Cat bonds are priced at a discount because of the high amount of credit risk. If an earthquake already happened, that is the trigger that allows the seller of the bond not to repay the loan or to only repay a portion of the loan (maybe the principal repayment was based on the Richter Scale). You cannot predict when an earthquake is "about to happen". After the even happens, the bonds will be even more discounted, but I would call it impaired vs discounted because they will never get back to par value.

Anyway, we are getting off topic. My question was about single tranche trading. Once again, if you own a single tranche CDS, the value should increase as the payoff increases and this will happen when there is more systemic risk.