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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: Hawkmoon who wrote (101183)	2/11/2009 8:58:16 PM
From: forceOfHabit	Read Replies (2) \| Respond to of 110194

Hawk, Don't ask me, ask George Soros: Ummm, right. Why don't we just think for ourselves a little first. You can find a basic discussion of credit default swaps (CDS) here: en.wikipedia.org, but I believe the following is pretty self contained: Suppose you are a hedge fund that thinks they know a thing or two about credit and default risk. For simplicity lets assume we're dealing with one year maturity bonds. Treasuries (risk free) pay 1%. The bonds of company A pay 6% per year. They pay this much because there is a chance they will default before maturity. The spread compensates the corporate buyer for the probability of default. (A 5% spread = roughly a 5% chance of default - assuming no recovery in default blah, blah, blah -bear with me; we want to keep it simple.) If you think the company has a less than 5% chance of default, buy the bonds. (Fund the purchase by shorting treasuries blah, blah, blah but we'll ignore that part in the interest of keeping it simple.) If you think the company has more than a 5% chance of default, short the bonds. Ah. Easier said than done. First you have to find someone who owns the bonds and is willing to lend them to you. Then after you have shorted you need to be reasonably sure you can buy them back. Total pain in the ass. How about this instead: Find someone (investment bank, bond mutual fund, pension plan, widow, orphan...) who thinks the bonds are a good buy. Offer them a CDS: they keep their $100 principal in treasuries. You pay them the extra $5 (5%) per year but if Company A defaults, they owe you the full principal ($100). They are effectively long the bonds. You are effectively short. In this case, you are said to be long the CDS (short the bonds), they are said to be short the CDS (long the bonds). So far so good? Notice that the most they can make (in excess of treasuries) is $5. The most they can lose is $100 (the principal). Opposite for you. Big leverage (20:1) but a long way from "unlimited". Imagine that the company is not some flea bag that trades 500bp over. Imagine Moody's or S&P or Fitch or some "credible" rating agency has rated them AAA and they trade at 50bp (0.5%) over treasuries. Leverage now for the CDS is 200:1. Its certainly not unlimited, but you can see how, with a portfolio of this stuff, inadequate risk management, and a little poetic license Soros might have called it "practically unlimited". Basically, its no different than shorting a put option on a stock. You receive a small(ish) premium and are potentially on the hook for the whole strike price. Big leverage. Big (but finite, and quantifiable) risk. It is not at all* like shorting a stock (Small (1:1) leverage. Big (theoretically unlimited) risk). 'Nuff said? habit *Unsurprisingly, many hedge fund credit models do credit arb with a model that has the bondholders implicitly short a put on the enterprise value of the firm blah, blah, blah I thought we were keeping it simple?