A Credit Default Swap is not economically identical to a put option on a bond. The CDS only triggers payment on actual default. A bond put option is more valuable as it may have a payoff even if the issuer has not defaulted (curve steepening &/or spread widening, for example).
This should not stop a listed market for CDSs developing, but let's stop calling them "swaps" first. This anachronism is a result of the product emanating in credit land which plainly likes everything to be quoted in terms of spreads. When an issuer gets into difficulties, CDSs rapidly morph into being quoted with an up front premium - Morgan Stanley suffered this ignominy - and this is the way an exchange traded product must surely be constructed. Here's a possible (rather simplified) specification for a listed Default Option:
- Reference Bond: $[ ] par amount of XYZ 8% of 2020
- Cost: $[ ]% of par
- Strike Price: [100]% of par
- Expiry: 5 years
- Settlement: Physical or Cash on Event of Default
- Physical Settlement: Delivery of Reference Bond for Par
- Cash Settlement: Max(0, Strike Price - Default Settlement Price)
- Default Settlement Price: Auction to occur [ ] days after Default Date
- Settlement Trigger: Event of Default must have occurred as determined by [ ]
Come to think of it, how hard it is for many benchmark bonds to be exchange traded as a result of staggering technological advances of the last 20 years? Stock exchanges presently list bespoke equity derivative products at the drop of a hat with very little fuss. Opacity equals profitability for the sell side, I suppose; it has always puzzled me why the bond market, many multiples the size of the equity market, has transparency a fraction of that of the equity market. ICAP & Garban IDBs might just get a little bored were this to come to pass.
3 Comments:
The equity markets are more transparent than fixed income markets as the former see a larger number of individual investors, who are considered "naive" market participants by regulators.
Hear hear
Sovereign FI is full of naive participants through MM funds and the like, granted that's not the case in corp credit. I don't understand the habit of opacity other than a monopolisitc hold on information by Bloomberg or simply that no one can be bothered to put it in place. Here's to another revolution for access to information and transparency.
Also agree with the calls for listed contracts, however think a bank owned clearing co is the likely outcome.
In the U.S., the TRACE system for corporate bond prices has been in place for several years. Thanks to TRACE, corporate bond spreads tightened tremendously, old-time corporate bond dealers lamented their shrinking profits. Now spreads are wide due to lack of buyers, not lack of information.
Also, Andrew, CDS can be triggered for events other than default. Look at FNM, FRE and Iceland: CDS triggered on those, and all FNM and FRE debt continues to be money good. Iceland has defaulted on some bonds, according to Reuters, but not all, so you have a Cheapest To Deliver problem there.
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