A credit default swap (CDS) is in effect an insurance policy on the default risk of a corporate bond or loan. To illustrate, the annual premium in July 2011 on a five-year Citigroup CDS was about 1.3%, meaning that the CDS buyer would pay the seller an annual premium of $1.30 for each $100 of bond principal. The seller collects these annual payments for the term of the contract, but must compensate the buyer for loss of bond value in the event of a default.
As originally envisioned, credit default swaps were designed to allow lenders to buy protection against losses on sizable loans. The natural buyers of CDSs would then be large bondholders or banks that had made large loans and wished to enhance the creditworthiness of those loans. Even if the borrowing firm had shaky credit standing, the “insured” debt would be as safe as the issuer of the CDS. An investor holding a bond with a BB rating could, in principle, raise the effective quality of the debt to AAA by buying a CDS on the issuer. This insight suggests how CDS contracts should be priced. If a BB-rated bond bundled with insurance via a CDS is effectively equivalent to a AAA-rated bond, then the fair price of
the swap ought to approximate the yield spread between AAA-rated and BB-rated bonds. The risk structure of interest rates and CDS prices ought to be tightly aligned. Figure 10.11 , Panel A, shows the average prices of five-year CDSs on U.S. banks between mid-2007 and 2011. Notice the sharp run-up in prices in September 2008 as Lehman Brothers entered bankruptcy and the financial crisis peaked. CDS prices fell back, but then they increased again in 2009 in the depths of the recession. As perceived credit risk increased, so did the price of insuring that debt.
CDS contracts also trade on the sovereign debt of a wide range of countries. Panel B of Figure 10.11 shows the prices of five-year CDS contracts on German debt. Even with Germany being the strongest economy in the euro zone, German CDS prices nevertheless reflect financial strain, first in the great recession of 2009 and then again in 2011 as the prospects of default (and a German-led bailout) of Greece and other euro zone countries worsened. Still, even in late 2011, German CDS prices were only about one-third of those on U.S. banks.
While CDSs were conceived as a form of bond insurance, it wasn’t long before investors realized that they could be used to speculate on the financial health of particular companies. As Figure 10.11 makes clear, someone in August 2008 wishing to bet against the financial sector might have purchased CDS contracts on those firms and would have profited as CDS prices spiked in September. In fact, hedge fund manager John Paulson famously did just this. His bearish bets in 2007–2008 on commercial banks and Wall Street firms as well as on some riskier mortgage-backed securities made his funds more than $15 billion, bringing him a personal payoff of more than $3.7 billion.
While CDSs were conceived as a form of bond insurance, it wasn’t long before investors realized that they could be used to speculate on the financial health of particular companies. As Figure 10.11 makes clear, someone in August 2008 wishing to bet against the financial sector might have purchased CDS contracts on those firms and would have profited as CDS prices spiked in September. In fact, hedge fund manager John Paulson famously did just this. His bearish bets in 2007–2008 on commercial banks and Wall Street firms as well as on some riskier mortgage-backed securities made his funds more than $15 billion, bringing him a personal payoff of more than $3.7 billion.
No comments:
Post a Comment