The stock price effect of the introduction of exchange-traded credit derivatives

Abstract

This research investigates the stock market reaction to the February 2011 announcement of a new financial product: credit event binary options (CEBOs). The CEBOs could be an alternative to credit default swaps for hedging or speculating on default. These credit options, traded on the Chicago Board Options Exchange (CBOE), pay-off only in the event of default by the underlying firm. Options were initially introduced for 10 firms from various sectors of the economy. In April 2011, additional CEBOs were introduced for five large banks. This study finds that the announcement of the binary options did not have a significant negative effect on the stock prices of the underlying firms. These firms did have a significant negative cumulative abnormal return over the entire event window surrounding option announcement. Analysis of trading volume finds that the majority of the CEBOs did not trade at all during the first 110 days after listing. Results indicate that market participants are not utilizing exchange-traded credit options for hedging credit exposure or speculating on credit default.

Keywords:

• binary option
• credit default
• event study
• derivatives

JEL Classification:

• G10
• G14

Notes

1 The $1000 option indicates the target market was retail brokerage. The Exchange had offered CEBOs previously; the contract size was $100 000. These contracts were discontinued, presumably due to lack of investor interest. Only a small number of contracts traded in 2007 and 2008. None traded in 2009 (CBOE, 2007, 2008 & 2009).

2 For the stocks that had CEBOs announced on 22 February 2011, betas were computed over the period 7 January 2010 to 6 January 2011. Betas for the banks were computed over 11 March 2010 to 10 March 2011. We then computed the abnormal returns (ARs) and cumulative abnormal returns (CARs) over the period 7 January 2011 to 5 April 2011 in order to consider the effect of the CEBO announcement on the first 10 stocks. For the banks, we computed ARs and CARs over the period 11 March 2011 to 7 June 2011.

3 Additional analysis was performed using the first trading day as the event day. We also computed ARs and CARs over the period 24 January 2011 to 19 April 2011 to consider the effect of the first day of trading for CEBOs. For the banks, we computed ARs and CARs over 12 March 2011 to 8 June 2011 to consider the effect of the first day of trading. The results were similar to the results using announcement day as the event day.