Tranche Options Stall On Pricing Problems
This article appears courtesy of Institutional Investor
Source: Derivatives Week
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.