CDS

January 30th, 2009 2:56 am | by John Jansen |

JPMorgan will make available to ISDA as open source technology the methodology it employs to price CDS. This is admirable but if everyone employs the same methodology, there will be very few pricing anomalies to arbitrage. Hat tip to the Alea blog.

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  1. 8 Responses to “CDS”

  2. By Gabriel on Jan 30, 2009 | Reply

    Well, it won’t make much of a difference, as people use CDSW on Bbg anyway. The only difference is that people may be able to look at waht precisely are the assumptions behind they prices they get from the screen.

  3. By Gabriel on Jan 30, 2009 | Reply

    Well, it won’t make much of a difference, as people use CDSW on Bbg anyway. The only difference is that people may be able to look at waht precisely are the assumptions behind the prices they get from the screen.

  4. By Torp on Jan 30, 2009 | Reply

    Do we really need a model to price worthless assets?

  5. By Gabriel on Jan 30, 2009 | Reply

    @Thorp
    the “S” in CDS stands for Swap, which is a derivative contract between two counterparties. How can you say that it’s “worthless”? Like a standard IRS its NPV can be either positive or negative according to the fixed/swap rate relationship. Similarly a CDS NPV can be either negative or positive according to the relationship between the coupon you are paying for protection and the actual quoted spread. If you bought a 10Y protection in 2006 such contract is likely to be worth a LOT of money right now.

  6. By Andrew on Jan 30, 2009 | Reply

    Arbitrage in CDS does not correct the pricing as explained by George Soros below

    “On a deeper level, too, credit default swaps played a critical role in Lehman’s demise. My explanation is controversial and all three steps of my argument will take the reader to unfamiliar ground.

    First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market. (Being long means owning a stock, being short means selling a stock one does not own.) Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

    The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

    The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.

    No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information”

  7. By Andrew on Jan 30, 2009 | Reply

    the full article can be found here,
    http://www.ft.com/cms/s/0/49b1654a-ed60-11dd-bd60-0000779fd2ac.html

  8. By Torp on Jan 30, 2009 | Reply

    Gabriel,
    you failed to understand the gist of my post.

    In the current environment where the authorities change the rules of the game when they seem fit, and where they seek ways to not let CDSs trigger a La Lehman…how can a model value these assets with ever changing variables?

    But theoretically speaking, you are correct on your explanation.

  9. By Andrew on Jan 30, 2009 | Reply

    All models are BS in my opinion and just used to soothe investors. Most of the people working those models know they are BS. I would also say that about PE ratios etc because any firm can fudge their numbers and most do. As long as humans with greed, fear, passion, loathing etc control the flow of numbers their will always be turmoil in the market.

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