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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