The Short View: Credit swaps
The Short View: Credit swaps
By John Authers, Investment Editor
Copyright The Financial Times Limited 2007
Published: July 31 2007 18:12 | Last updated: July 31 2007 18:12
Did the risk of default on US investment grade bonds really triple over the last month? And having done so, did this risk really drop by a third over the ensuing 24 hours?
Of course not. But movements in the prices of credit default swaps, which allow investors to buy protection against defaults, suggested exactly that. So we now know that the market for credit derivatives, which did not exist even five years ago, is inefficient.
That is no surprise. Markets do not always trade in line with fundamentals. All asset classes show inefficiencies, and much money is made exploiting them.
But this latest spasm raises questions about the vast and unruly market for credit derivatives. How does it operate, and how to gauge fundamental value?
The way the price of default swaps has ricocheted in the last few days appears to reflect a market in which there are only a few ultimate “sellers” (at the big investment banks), who if they do not feel confident about their ability to hedge their exposures can simply mark prices up to unrealistic levels. This is much less efficient than the markets for stocks or bonds.
As for the fundamentals, moves in swaps prices have far outpaced moves in underlying bonds. Both should be tied to the the risk of default, which has been cyclical in the past. Corporate defaults are running at historic lows at present, so they are likely to increase.
However, cool-headed analysis suggests that the cost of default insurance went beyond anything rational. At the end of last week, George Bory at UBS produced calculations showing that credit insurance prices implied that defaults would rise by more than 6 per cent in a year. This is conceivable, but Mr Bory points out that this has not happened in 25 years.
Calculations like this helped buyers regain their nerve this week. But the inefficiency of the market did not go away: it would be unwise to assume that credit’s convulsions are over.
By John Authers, Investment Editor
Copyright The Financial Times Limited 2007
Published: July 31 2007 18:12 | Last updated: July 31 2007 18:12
Did the risk of default on US investment grade bonds really triple over the last month? And having done so, did this risk really drop by a third over the ensuing 24 hours?
Of course not. But movements in the prices of credit default swaps, which allow investors to buy protection against defaults, suggested exactly that. So we now know that the market for credit derivatives, which did not exist even five years ago, is inefficient.
That is no surprise. Markets do not always trade in line with fundamentals. All asset classes show inefficiencies, and much money is made exploiting them.
But this latest spasm raises questions about the vast and unruly market for credit derivatives. How does it operate, and how to gauge fundamental value?
The way the price of default swaps has ricocheted in the last few days appears to reflect a market in which there are only a few ultimate “sellers” (at the big investment banks), who if they do not feel confident about their ability to hedge their exposures can simply mark prices up to unrealistic levels. This is much less efficient than the markets for stocks or bonds.
As for the fundamentals, moves in swaps prices have far outpaced moves in underlying bonds. Both should be tied to the the risk of default, which has been cyclical in the past. Corporate defaults are running at historic lows at present, so they are likely to increase.
However, cool-headed analysis suggests that the cost of default insurance went beyond anything rational. At the end of last week, George Bory at UBS produced calculations showing that credit insurance prices implied that defaults would rise by more than 6 per cent in a year. This is conceivable, but Mr Bory points out that this has not happened in 25 years.
Calculations like this helped buyers regain their nerve this week. But the inefficiency of the market did not go away: it would be unwise to assume that credit’s convulsions are over.
posted by Carlos T Mock @ 6:35 AM
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