Friday, 30 January 2009

Friday in Fantasy Land with George

I should buck up, I know. The current furore over credit derivatives may well come to nothing. But when I read something like Soros' article in the FT today, my heart sinks. Let's play spot the fallacy.
The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds.
So how can you explain the growth of CPDCs, who are long risk only CDS investors, or for that matter the long risk portfolios at the monolines and AIG? In reality the fact that CDS allows unfunded risk taking trumps the ability to go short in stimulating demand.

Note too that there can be no asymmetry in the market: you can't sell CDS protection unless someone buys it and vice versa.
...US and UK government bonds... actual price[s are] much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.
No they are not. (I don't believe in the strong form of the efficient market hypothesis either, but this is not evidence for or against it.) CDS spreads include counterparty risk effects and liquidity risk on the possible future margin. Bond spreads include funding premiums. They are literally incommensurate since to have hedged positions (bond plus CDS) you need to be able to fund the bond to term at a fixed cost and to have no counterparty risk on the CDS provider.

I have an unworthy, low conjecture. It is that the age of a commentator is directly related to their hostility to CDS. The older someone is, the later they are likely to have come to the CDS market. And the less likely they are to understand it.



Blogger alan.seager said...

i can't believe soros wrote that article. in addition to the things you mentioned, and the implication that AIG and Lehman are "victims", is the very fact that cds payout is NOT asymmetrical - if you short a cds you can only make par-recovery and sometimes much less (if cds is trading points up front). i wonder if george has ever traded a cds in his life. shocking.

2:20 pm  
Blogger David Murphy said...

Quite right Alan. I especially like your observation about CDS trading up front. If you are paying 10 or 20 points, then that's a pretty heavy penalty for being short...

9:09 am  

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