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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA


par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010
  

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2.12.2.2 CDS Netting

As far as any CDS contract is involved, the protection buyer as well as the protection seller of credit protection takes on counterparty risk in which it is spelt out that the protection buyer needs to take the risk which the protection seller will default in future. There exists this `double default' that only pops up when the triple A bank and the risky corporation default at

the same time thereby resulting in the protection buyer losing his protection against default by the supposed reference entity. At the same time, if either the triple `A' bank defaults but the risky corporation does not, then the protection buyer might need to replace the defaulted CDS but doing so at a very high cost.

Contrary to the above, the protection seller sometimes take the risk assuming the protection buyer will default on the contract thereby depriving the protection seller of any expected revenue stream. The protection seller and protection buyer both have different ways of handling the risks. The protection seller limits his risks by buying protection from another party hence hedging its exposure. If the original protection buyer drops out as a result of this, the protection seller doubles his position by either unwinding the hedge transaction or by selling a new CDS to a third party. Pending on market conditions the price at the time may be lower than that of the original CDS thereby implying a loss to the protection seller and vice-versa.

For instance let's consider an investor buying a CDS from a triple `A' rated bank having a risky corporation as the reference entity. In this case, the protection buyer of the protection is the investor who will make regular payments to the triple `A' rated bank-the protection seller of the protection. Note that should the risky corporation default on its debt, the investor will eventually receive a one-time payment from the triple `A' bank terminating the CDS contract.

The first ever existed CDS was in the early 1990s although the market only increased at the beginning of 2003 up to the end of 2007 and fell by the end of 2008. The increase of these CDSs during this period is because the CDSs help in completing markets to investors since they provide effective means to hedge and trade credit risk. This is achieved by the CDSs allowing credit risk to be hedged separately from interest rates. Also, CDSs allow financial institutions to manage their exposures better thereby making it possible for investors to

benefit from enhanced investment. In addition to this, CDSs spreads provide a valuable market-based assessment of credit conditions. The strong growth of this CDS market is because of financial institutions' desire of better managing credit risk and of traders gaining exposure to the credit markets. All in all, the main reason behind the growth of the CDS markets during this period was because most banks used the CDS spreads as a measure of their credit risk as well as their risks management tool (buying credit protection through CDS). CDSs were used as trading tools as well as a means of allocating risks efficiently.

The major reason for the fall of the CDS markets by the end of 2008 was as a result of the collapse of Lehman Brothers. As if this is not enough, it is argued that the enhanced transparency in CDS would instead result in lowering the risks of excessive market reactions. A case in point is the collapse of Lehman Brothers which provided a vivid example on how insufficient transparency may result to market reactions overshooting.

Table 3: The ISDA Market Survey for CDSs

Notional amounts (in billions of US dollars), semiannual data, all surveyed contracts, 2002- 2009

Period

CDS Outstanding (billions of USD )

2H02

2,191.57

2H03

3,777.40

2H04

8,422.28

2H05

17,096.14

2H06

34,422.80

2H07

62,173.20

Figure 8: Increase in CDS Markets

Source: ISDA Market Survey

The graph above illustrates an increment in the CDS markets. The increase was as a result of how investors used these CDSs for many reasons such as hedging and trading risks as well as in managing their exposures.

Most of the time, credit events are referred to as defaults and they include events such as failure to pay, restructuring and bankruptcy. In situations where the reference entity defaults, the triple `A' bank pays the investor the difference between the par value and the market price of the specified debt obligation. This is mostly referred to as cash settlement.

The major difference existing between insurance and CDS is that insurance contracts provide indemnity against losses suffered by policy holders while the CDS contracts provide equal payout to all holders, using the agreed, market-wide method of calculation. As if that is not enough, with insurance contracts, all the risks involved needed to be disclosed whereas with

CDSs they are no such requirement. The CDSs protection sellers are not required to maintain any capital reserves to serve as guarantee payment of claims unlike the insurance companies where it is a necessity.

Defaults are usually referred to as credit events since they entail events such as failure to pay, restructuring and bankruptcy. Statistics show that most CDSs range between $10 to $20 million with maturities varying between 1 and 10years. Most of the time, the bond holders buy protection so as to hedge their risks of default thereby making CDS to be similar to credit insurance though different from some other governing regulations.

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