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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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2.12.2.3 Naked CDSs

CDSs are considered as `naked' when they allow traders to buy CDSs who neither own the underlying bond nor is otherwise exposed to the credit risk of the reference entity. Hence making it possible for investors to be able to buy and sell protection without owning any bonds. Usually, the buyer of the naked CDS protection tries to exploit the arbitrage opportunities that are taking advantage of the differences in the risk pricing between the bond and the CDS markets and trying to benefit from the rise in credit risk. Naked CDSs are considered as not serving any useful purpose and are therefore looked upon as to be dangerous. They do not help in either price discovery or in any liquidity because they might instead affect the funding cost.

The most important and obvious argument against naked CDSs is related to their moral hazard. This usually arises when it is possible to insure without an `insurable interest'. This therefore implies they do not create any values. They influence the interest level of original transactions which can be compared to taking out life insurance on someone else's life. Naked CDSs increase leverage which usually comes at low costs to the default of the reference entity. This implies they can substantially increase the losses that come from defaults.

Therefore naked CDSs should be forbidden because they do not have a purpose in the society and the society does not benefit from them. With naked CDSs, only one party is the winner while the others lose.

To an extent, these naked CDSs contributed to the out break of the present global financial crises. This is because they involved a lot of gambling with no social or economic benefit. As a result of this, naked CDSs have played an important role in destabilising the financial system. Note that these naked CDSs constitute a large part of all CDS transactions and CDS as whole is being associated with insufficient transparency. The collapse of the Lehman Brothers was as a result of this insufficient transparency portrayed by these CDSs. The problems encountered by Lehman Brothers and its eventual collapse were the onset of the present global financial crisis.

2.12.2.4 Uses of CDSs

Investors use CDSs to speculate on changes in the CDSs spreads of single names thereby creating a more competitive market place where the prices are kept down for hedgers. Investors do belief that any entity's CDSs spreads are either too high or too low compared with the entity's bond yields. With the help of CDSs spreads, investors can speculate on an entity's credit quality because it is generally belief that CDSs spreads increase as creditworthiness declines and vice-versa. CDSs are known to be used to structure synthetic CDOs. This is in the sense that, instead of owing loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS.

Most of the time, CDSs are used in managing risks of default arising from holding debts. For instance, let's consider a bank hedging its risks on a borrower being at default on a loan by entering into a CDS contract as a protection buyer. If the loan happens to go into default, the proceeds from the CDS contract will eventually cancel the losses on the underlying debt.

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