It may be a bit esoteric as an intellectual exercise for day one in a new job. All the same, when Helen Weir takes up the post of finance director of Lloyds TSB, she might find the relationship between the bank’s credit spreads and the price of its equity options rather interesting.

From a risk point of view the debt and equity markets cannot make up their minds what they think of Lloyds. Narrow credit spreads mark it out as low risk but high implied volatility (derived from equity option pricing) suggest that equity investors have a different point of view.

The conclusion is that investors should buy the equity and wait for it to re-price.

Since the tech crash, investors have become more interested in the relationship between credit and equity since a lot of them got burned by not realising that high gearing would eventually hit stock prices.

Their concerns, however, were about avoiding downside risk. Now analysts are finding ways to arbitrage differences in pricing and reap some upside. A new model from Commerzbank, comparing credit spreads and equity option prices, or debt risk with equity risk, has come up with some interesting anomalies, such as the Lloyds example.

Rolf Elgeti, Commerzbank’s head of debt and equity strategy, says: “When we notice an arbitrage opportunity we find it takes about three months for the market to come back in line. Usually the equity market catches up with the bond market.”

And for those fund managers who are not allowed to invest across markets, Mr Elgeti will be delighted to show them an in-market arbitrage between two equity stocks or credits in a sector.

Ms Weir, who no doubt will be holding some stock options of her own, may like to give him a call for the latest news on Lloyds’ option pricing versus its credit spreads.

When granny starts receiving marketing literature for hedge funds, does it mean the market is mature?

Brian Caplen

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