Tranche Options Stall On Pricing Problems

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This article appears courtesy of Institutional Investor
Source: Derivatives Week
Abigail Moses

The nascent index tranche options market is being held back because few dealers are willing or able to quote prices, preventing a liquid market from taking shape. Only a handful of firms in the U.S., among them Merrill Lynch, are pricing tranche options, but other dealers are holding off from entering the fray. The identities of the other active firms could not be ascertained.

Dealers said they are focused on better modeling the tranches themselves, rather than moving on to the next generation of tranche trading. "It's possible this product will get more attention," said Jeff Meli, director and head of U.S. structured credit and quantitative strategy, at Barclays Capital in New York. "But it's a second-order modeling problem," he added, referring to his team's focus on other modeling issues.

In traditional option pricing, dealers plug spread, correlation and volatility assumptions into the Black-Scholes model. But in this instance these variables are too uncertain to use for tranche pricing, dealers said. The result is that over the past few months it's been difficult to model forward-looking prices as correlation has been so volatile.

If interest develops and investors want to trade tranche options, traders not currently pitching the instruments said they will price them with a significant cushion, but only in bespoke form. The most popular forms, at this point, are cleanup calls and callable tranches, where investors sell the right to put trades in the future.

But those firms pricing the instruments dismissed pricing difficulties and also noted there is growing investor demand for tranche options. "We see increased demand every day," said Zvi Gillon, v.p. in structured credit trading at Merrill in New York. Gillon said clients, primarily hedge funds, have been trading tranche options since February with growing interest. Merrill has started offering options on a range of tranches and tenors, he added.

Other dealers disagree about exactly how much demand there is for the market. Most firms not offering tranche options said the reason is lack of interest. "It's not clear the market needs them," said one structured credit trader. "It's not clear who the natural end users would be, and we're not seeing enough interest to justify the effort." One official at a firm offering tranche options said they can be used as hedging tools and are suitable for a wide range of investors. But he said it is clear the market will need more liquidity before many investors feel comfortable trading such options.