[Groty]

[/ QUOTE ] are there options on corporate debt? thats a good way to bet on bankruptcy i think if it were feasible, buy OTM puts on the debt if you think there is a larger than priced in chance the corporation will file chapter 11.

[/ QUOTE ]

Yes. They're called credit default swaps. All the big investment banks make a market in them. It's a non-transparent, very lightly regulated market making it nearly impossible to know who owns them, who has written them, or whether or not the writer of the option will be willing and able to perform in the event of a credit default. They trade over the counter and don't go through an option clearing house, so it's really the wild west.

In the benign credit environment of the recent past, writing credit default swaps has been like free money. Hedge funds have approached them like insurance, belieiving that if they write CDS on a large number of creditors, the premia from the issuers who don't default will cover their obligations against the few that do after recovery. They certainly have super sophisticated models to assess value at risk, but it's really a grand untested experiment. My feeling is that adverse events in insurance happen more or less randomly. For example, if a neighbors house 3 blocks aways accidently catches on fire, there's no reason to think my house will accidently catch fire. But when an economy turns down, financial distress begets financial distress. The primary element of randomness that makes insurance work is violated. It's going to be interesting to see how it plays out in the next downturn.

CDS do add to volatilty. Delphi is a good example. Before Delphi defaulted a couple of years ago, the notional value of the CDS written on Delphi debt far exceeded the par value of the Delphi debt outstanding. Perversely, when Delphi finally filed for bankrtupty, the value of Delphi's bonds actually spiked. Did they spike because the debt had suddenly become more valuable upon the bankruptcy filing? No, they spiked because many of the writers of the credit default swaps bought the bonds in the open market at a discount to par rather than risk having the credit default swaps assigned to them at par.