Credit Default Swaps: Useful, Misleading, Dangerous?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Richard Portes, in a recent VOXEU communique (April 30^th), asks this question about the use of Credit Default Swaps (CDSs).  In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.

 

CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party.  The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses.  These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position.  This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity. 

 

The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread.  European politicians blamed the CDS market for destabilizing Greece.  As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt. 

 

The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt.  Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.

 

CDS contracts can provide a useful function for price discovery and hedging positions.  However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.

 

Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market.  He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis.  In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated. 

 

Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets.  However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous.  In this case, naked CDS positions, however, may increase systemic risk.   Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7922

Italy – Systemic Risk or Self Inflicted

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The sudden surge in Italian debt yields raise questions about whether Italy has become a victim of European contagion or are the wounds self-inflicted?  This question is raised by Paolo Manasse and Guilio Trigilia in a recent paper Little time for Italy (VOXEU, Manasse & Trigilia, July 19^th).  The rise in unanticipated risk may prove costly.

The Eurozone crisis now extends to Italy.  The authors analyze 5-year credit-default-swaps (CDS) data and reach two conclusions: that Italy’s troubles are home-grown and the default risk is concentrated in the short run.

A number of well known factors contribute to Italy’s vulnerability: large deficits and surging debt levels, low productivity, an aging population and a large corrupt, inefficient bureaucracy.  This situation is aggravated by minimal fiscal reforms, a new budget of smoke and mirrors where most spending cuts are not implemented till 2013-2014. 

The authors ask three questions:  the first question is breaking the CDS spread component into euro-wide and country specific factors to obtain the country’s contribution to a European rather than country specific risks.  The findings suggest the Italy’s coefficient is near one indicating that spreads are more closely linked to the Eurozone than being country specific.  The second question is how much the euro-dimension explains Italy’s credit-default-swap premium.  The findings suggest Italy’s spread variance is less attributable to the euro component and most recently explained by country specific factors as the markets judge Italy on its own merits.  Lastly, what is the perceived risk of Italian debt at different time horizons?   The authors calculate the hazard rate of default (instantaneous probability) for bonds of different maturities (starting daily in 2007) to see the market view of the timing of the default.  The hazard rates are calculated daily for bond maturities of 1-10 years and plotted in a slope.  A positive slope means that the default rate is higher in the future.  The results show a sharp negative slope indicating the highest risks are concentrated in the short term, especially as the slope turned sharply negative over the last couple of weeks.

The verdict on Italy has not fully emerged yet, but the jury is still out as risks are concentrated in the very short run.  Italian leaders such as Mr. Berlusconi and Mr. Tremonti should take note as well as European leaders.  Do you have exposure to unanticipated risk?

 

For more on this story and the work of Mr. Manasse and Mr. Trigilia click on the link: http://tinyurl.com/45yoxmy

The Risk of Contagion in Europe – Evidence from Credit Default Swap Spreads

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The majority of analysts suggest that Greece is insolvent.  The issue for investors and risk managers is whether Greece’s troubles are contagious.  The authors lay out a framework to test whether Greece’s troubles can cause contagion.    

Investors and policymakers are split into two views on dealing with Greece: the bail-in-ers want a coercive (but soft) restructuring of Greek debt while bail-out-ers favor procrastination with continued EU-IMF lending to Greece.  There is no disagreement about whether Greece is broke.         The argument among in-ers and out-ers hinges on the fear of contagion or spill over into other markets.  There is concern that investors could over-react and flee Spanish and Italian debt forcing a European sovereign debt and banking crisis. This could force the choice between a full-blown monetization and/or a break-up of the euro.

The first test the authors perform is to look at the volatility of five-year European peripheral country Credit Default Swaps (CDS) spreads breaking it into a euro-wide and country wide spread component.  The euro-wide spread component has been declining for most of 2011 indicating a lower degree of “EU-bundling” of sovereign risk.  A second test looks at the factor weight of Greek CDS spread in a Euro-wide component. The factor weighting has declined significantly in the Euro-wide spread this year.  The last test shows that the correlation between Italian and Greek CDS spreads has declined steadily since late 2010. 

The evidence suggests that contagion has become less likely today than the past couple of years.  Markets bundled EU sovereign risks together for a long-time, but recently financial markets are starting to discriminate more.   There are two potential conclusions: the orderly restructuring of Greek debt should not produce an investor panic out of EU debt and second the fate of other problematic countries such as Italy rest in their own hands.  Risk managers need to be cautious, but the research suggests that fear of contagion may be overdone. 

 

For more on this issue, click on the link to VOX :The fear of contagion in Europe”, Manesse & Trigilia:  http://tinyurl.com/6ep63ha