Credit Event Binary Options (CEBOs) were first introduced by the Chicago Board Options Exchange (CBOE) in the second half of 2007 as a means of participating in the booming credit derivatives market. The most active credit derivatives at that time were credit default swaps (CDSs), the market for which had grown exponentially, from a notional value of $180 billion in 1998 to $57 trillion in 2007, according to the Bank for International Settlements. CEBOs represented CBOE’s attempt to translate CDSs, and CDS indexes to a regulated and centralized exchange.

However, CEBOs never had a chance to take off, as the development of a robust market for them was hindered by the global credit crisis of 2008. The Chicago Board subsequently launched redesigned CEBO contracts in March 2011. But three years later, the second attempt had proved to be no more successful than the first, as demand for credit derivatives was stifled by a global economic boom and a roaring bull market.

Basic features

CEBOs are designed to offer protection from so-called “Credit Events,” and thus are quite different from standard call and put options. Credit events typically refer to three adverse developments that can affect a company’s credit rating – debt default or bankruptcy, failure to pay interest or principal, or debt restructuring. However, the Chicago Board only specifies a single credit event for its CEBOs, i.e. bankruptcy, in order to reduce any ambiguity in defining a credit event.

CEBOs also have a binary outcome, paying a fixed maximum notional amount of $1,000 upon confirmation of a credit event (i.e. that the underlying company has declared bankruptcy) and expiring worthless if the company does not declare bankruptcy during the life of the option.

Price interpretation

CEBOs are quoted in penny increments beginning from a minimum tradeable price of $0.01 to a maximum tradeable price of $1.00. Each CEBO has a multiplier of 1000, giving it a dollar value between $0 and $1,000. The minimum tick value for a CEBO is thus $10 (i.e. the multiplier of 1000 x the minimum tick size of $0.01).

The price or premium of a CEBO is based on the sum of discounted probabilities of a credit event occurring over the life of the option contract. The premium therefore reflects the probability of bankruptcy in the underlying company occurring before the option expires. Thus, a premium of $0.20 reflects a 20% probability of bankruptcy during the option’s life, while a premium of $0.35 indicates a 35% probability of bankruptcy.

Types of CEBOs

There are two types of CEBOs:

  • Single-Names: These are CEBOs on a company (known as the “reference entity”) that has issued or guaranteed public debt that remains outstanding. CEBOs do not consider all the debt obligations of a company; rather, a specific debt issue identified as a “reference obligation” is used by CBOE to identify the occurrence of a credit event for the company. For example, as of March 2014, Bank of America (NYSE:BAC)’s 3.625% 2016 Senior Notes were the reference obligation for the December 2014 CEBO on Bank of America.
  • Basket-CEBO: This is a package of multiple “reference entities.” Basket-CEBOs can be referenced either to debt securities of companies in the same economic sector, or to debt securities of companies with the same credit quality. On the listing date, CBOE specifies various parameters of the basket such as its components and their weights. The recovery rate, which is the residual value of a company after bankruptcy, is also specified.

Example of a Basket-CEBO

For example, consider a basket with a notional value of $1,000, containing 10 equally weighted components in the energy sector (10% weight each), and with a recovery rate of 30% specified for each company. Most basket-CEBOs are structured for multiple payouts, meaning that a payout is automatically triggered each time a credit event occurs for a component of the basket, i.e. a constituent company declares bankruptcy.

The payout is calculated as: Basket’s notional value x weight of the component x (1 – recovery rate). Thus, in this example, if one company declares bankruptcy, the payout would be $70; it would be removed from the basket and the CEBO contract would continue to trade. If two companies declare bankruptcy, the payout would be $140, and so on. The maximum payout of $700 would occur if there was a global financial catastrophe and all 10 companies in the basket declared bankruptcy before the expiration of the CEBO.

Applications of CEBOs

  • Hedge corporate debt: A long position in a single-name CEBO can be effectively used to hedge the credit risk of a company’s debt, while a basket-CEBO can be used to mitigate credit risk of a specific sector. CEBOs can also be used to adjust credit risk of a bond portfolio as required.
  • Hedge equity exposure: CEBOs have a very high correlation with put option volatility. They can therefore be used as an alternative to puts in order to hedge equity exposure.
  • Hedge volatility: The correlations between stock prices, credit spreads and volatility typically spike during periods of financial stress, as was the case during the 2008 global financial crisis. A long position in a broad-based basket-CEBO may provide an effective hedge against extreme volatility during such times.

Pros Of CEBOs:

  • Since they are exchange-traded instruments, CEBOs have the advantages of being transparent, having standardized terms, and virtually eliminating counterparty risk.
  • The smaller notional size of the redesigned CEBOs – $1,000, as opposed to $100,000 in their earlier incarnation – makes them suitable for use by sophisticated retail investors.
  • CEBOs, like options, can be traded out of a securities account, making it a convenient way for equity traders to trade credit.

Cons Of CEBOs:

The biggest drawback of CEBOs is that anticipated demand for these products has failed to materialize. CBOE initially rolled out CEBOs on 10 companies in March 2011 and a month later added CEBOs on five leading financial firms – Bank of America, Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS). However, by March 2014, the only CEBOs available were on these five financial giants, with the only available expiration being December 2014.

The Bottom Line

The proposed transition of credit default swaps to exchanges like Intercontinental Exchange (ICE) and Chicago Mercantile Exchange (CME) may further diminish the limited appeal of CEBOs to institutional investors. However, CEBOs seem particularly useful for sophisticated retail investors, as they enable them to participate in the credit market – which was hitherto the exclusive domain of institutional players – and also provide them with an alternative to hedge their debt and equity portfolios. While there is little demand for CEBOs as of March 2014, the inevitable onset of a savage bear market in the years ahead may revitalize demand for them and perhaps lead to CBOE offering CEBOs on more issuers.

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