Market watchers often cite credit default swap (CDS) prices as indicators of an entity’s risk.
A credit default swap is essentially an insurance policy on a bond. A protection buyer in a CDS transaction pays a periodic premium to a protection seller. The protection seller promises to pay the protection buyer when a credit event, like a default, occurs.
Investors often buy CDS protection to hedge their positions bonds, such as corporate bond and sovereign bonds. And like with insurance, when risks rise, so do the premiums. As a result, rising CDS prices should indicate rising default risk.
However, critics think the thinly traded nature of the CDS market makes it very unreliable as an indicator of credit risk.
Just how thinly traded are these markets?
The Federal Reserve Bank of New York just released the results of a study conducted examine the impact of new public reporting rules on the CDS market. (These new rules are being proposed by the CFTC as part of the Dodd-Frank bill.) Among other things, the report reveals just how thin and inconsistent trading is in certain CDS. From the NY Fed’s study:
On average, trade frequency in single-name reference entities was relatively low and varied widely by reference entity. A majority of the single-name reference entities traded less than once a day, whereas the most active traded over 20 times per day. Few specific reference entities were consistently active during the period; the most actively traded reference entities changed markedly over our three month sample, suggesting that activity is often driven by specific credit or economic events impacting the credit quality of the underlier.”
The Wall Street Journal also conducted its own analysis on the illiquid nature of the CDS markets. They note that CDS can prove particularly unreliable during periods of volatility, which is when people pay extra attention:
While the swaps can help investors hedge risks and bet on market trends, the thin trading underlines a key shortcoming of an instrument that has a huge influence on risk perceptions. During periods of stress, the actions of a few traders can have an outsize impact on delicate market psychology.
As an example of relative illiquidity, they compare CDS volume against stock trading volume of Bank of America shares:
For the week ending Sept. 16, the most recent data available, the gross notional value of swaps referencing Bank of America—that is, the value of the contracts outstanding—rose from the prior week by $700 million, according to Depository Trust.
By comparison, some $8.5 billion of the Charlotte, N.C., company’s stock traded during the same week.
However, the CDS market may not be completely useless. Perhaps we can avoid the magnitude of CDS price moves, and just focus on the direction of CDS prices to see if default risk is rising.
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