# Repost: On negative basis trade

This is a repost of something i wrote in May 2010. The reason for the repost is that I want to use the power of Markdown to make it look “nice”.

On FT Alphaville there was a discussion on the persistence of a gap between the price of CDS on Greek Government Bonds (GGB) and the spotmarket price of GGB: As noted by Barclay Capital, the GGB spreads have widened relative to CDS premiums, allowing an arbitrage trade without default risk from the issuer of the bond.[1]
One possible explanation for the persistence of the gap between CDS premia and spotmarket may be the counterparty risk. First, approximate the probability of default of GGB by the spread:

$\Pr(D_{GGB})=r_{GGB} – r_f$

The value of the CDS from the perspective of a buyer is – for some value of recovery rate $$R$$, assuming no counterparty risk:

$CDS = (1-R)\cdot \Pr(D_{GGB})$

If we allow for counterparty risk $\Pr(D_{CP})$ this becomes:

$CDS = (1-R)\cdot \Pr(D_{GGB}) \cdot \Pr(1-D_{CP})$

Now, if we allow for the weak form of the efficient market hypothesis, a widening between GGB on the spotmarket and CDS-premia could have two sources: a rise in the expected recovery rate, or a rise in the perceived counterparty risk. Since S&P has set a low expectancy value on the recovery rate (between 30-50%, far below the average recovery rate for sovereign defaults), this persistent, and widening gap is only consistent with a widening in the counterparty risk.

[1]: One could buy the bond and buy default protection – a CDS – and cash in the difference between the bond interest rate and the insurence premium.

# Ein Interview von 1999

Ich bin zufällig über ein Interview mit Martin Mayer gestolpert, das von 1999 ist, und in dem Mayer damals schon die Schwachstellen der „Finanzmarktinnovationen“ beschreibt, und deren Versagen im Krisenfall vorhersagt. Hier ein paar Ausschnitte:

That’s the secret of the JP Morgan lawsuit with the Korean banks. It was Korean Central Bank money that these guys pissed away. You had this incredible device—a Malaysian corporation formed to write instruments that would pay off according to the relative values of the Thai baht and Japanese yen, and designed solely for the purpose of selling these instruments to the Korean banks because the Korean Central Bank wanted to increase the return on its reserve.

Once you start to get into this sort of nonsense, serious problems can occur for everybody, because you are dealing in a world of thoroughly artificial instruments that have nothing to do with real production, real consumption, real trade or real anything. They are simply counters in a game. But when the players have to pay off, they have to pay off in real resources, and that sort of thing is extremely dangerous over time.

In October 1997, when the Brazilian real came under dramatic attack, nobody could figure out why. It turned out that in September ’97, between 20 percent and 25 percent of all the Brazilian Brady bonds were held by South Korean banks. The Brazilian Brady bonds had a large, liquid market because people were making a lot of money trading them and trading derivatives off of them. So when the South Korean banks got in trouble, the easiest thing for them to do was to sell Bradys. The bonds took a hit and the real took a hit. And that’s crazy.

It’s one thing to talk about a spillover effect with countries that are closely related to each other. It’s another thing to talk about contagion. There have been artificial links created between currencies because of the statistical correlation in their path behavior. That has nothing to do with anything. Correlations and causes can get mixed up anytime, but the notion that you put hard money on correlations where there is no—and can be no—causation other than the correlation itself is bad news.

What’s really happening is that the guys selling the hedging instruments are writing a form of insurance. It’s catastrophe insurance, but they don’t know it’s catastrophe insurance, so they have no way to price it that gives them accurate premiums for the risks. Nobody knows. The question is whether there shouldn’t be some regulator making sure that when the insurance doesn’t pay off, important players don’t go absolutely insane and bust. That’s got to be addressed.

Banks are supposed to do information-intensive lending. The notion that the ratings agencies know what the risks are on loans better than the banks do—well, that’s really remarkable. It means that everybody has adjusted to a world in which banks are not going to hold loans in their portfolios. They are going to sell them off. And the ratings are important for the purpose of selling off the loans.

We’re moving from a world that was dominated by specific information in banks to a world dominated by much less profound but much more widespread information in markets. The clash between these two systems of valuing instruments is what makes for the instability that we can see all around us and that will increase.

There’s obviously a real value in credit derivatives because they allow the farm-belt bank and the rust-belt bank to swap exposures. By diversifying, both of them have less risk. The reduction of their returns is minor because the cost of these contracts is minor.

In some cases, you’re not swapping portfolios of loans. You’re gambling on the relative return of a risk-free instrument against an equity portfolio, a portfolio with junk bonds, a portfolio of foreign currencies or whatever, in which there is a larger risk.Nobody knows what the hell is going on in these private deals, and nobody knows the volume of what is out there, including regulators. So nobody can have an informed opinion about what the dangers are. What has happened over and over again with these instruments is that people have assumed that there is measurable risk where in fact there is immeasurable uncertainty.

# On the negative basis trade

Okay, my first post in English, mainly because this is in respond to a discussion i found on FT Alphaville. Because I prefer some neat mathematical writing, find the post in the attached PDF. The conclusion of the article is that a widening in the gap between CDS premia and Greek government spreads is an increase in the perceived counterparty risk of the CDS.

Find the PDF here: On negative basis trade

# On the negative basis trade

On FT Alphaville[1] there was a discussion on the persistence of a gap between the price of CDS on Greek Government Bonds (GGB) and the spotmarket price of GGB: As noted by Barclay Capital, the GGB spreads have widened relative to CDS premiums, allowing an arbitrage trade without default risk from the issuer of the bond.[2] One possible explanation for the persistence of the gap between CDS premia and spotmarket may be the counterparty risk. Taking some basis valuation formula, one has for the probability of default of GGB:

The value of the CDS from the perspective of a buyer is – for some value of recovery rate r, assuming no counterparty risk:

If we allow for counterparty risk , this becomes:

Now, if we allow for the weak form of the efficient market hypothesis, a widening between GGB on the spotmarket and CDS-premia could have two sources: a rise in the expected recovery rate, or a rise in the counterparty risk. Since S&P has set a low expectancy value on the recovery rate (between 30-50%, far below the average recovery rate for sovereign defaults), this persistent, and widening gap is only consistent with a widening in the counterparty risk.

[1] http://ftalphaville.ft.com/blog/2010/05/06/221576/the-gr%CE%B5%CE%B5k-n%CE%B5g%CE%B1tiv%CE%B5-b%CE%B1sis-tr%CE%B1d%CE%B5/

[2] One could buy the bond and buy default protection – a CDS – and cash in the difference between the bond interest rate and the insurence premium.

# Freikörperkultur – CDS-Ausgabe

Heute mal ein paar Artikel über Credit Default Swaps. Insbesondere die Möglichkeit, CDS zu kaufen, ohne den Basiswert (also eine Anleihe des im CDS spezifizierten Emittenten) zu besitzen (nackte CDS), wird häufig als sinnlos, zum Teil sogar gefährlich für die Finanzmarktstabilität beschrieben – siehe nakedcapitalism.com und die dort verlinkten Artikel.

FT Alphaville macht hingegen das Gegenbeispiel auf: Diejenigen, die vor allem nackte CDS gekauft haben, sind Hedgefonds, die dies lange Zeit vor Ausbruch der aktuellen Krise getan haben, in der Erwartung, dass die damals ungewöhnlich niedrigen Risikoaufschläge für südeuropäische Staatsanleihen steigen würden. Aktuell sind diese Hedgefonds vor allem Verkäufer von CDS, d. h. sie schließen ihr spekulatives Geschäft, und ermöglichen gleichzeitig Banken, die griechische Anleihen halten, ihr Risiko abzusichern. Dieses Angebot von den Spekulaten ist insofern auch gesamtwirtschaftlich sinnvoll, weil es die Liquidität auf diesem Markt erhöht.

Felix Salmon kritisiert detailliert die Artikel von Münchau und Morgenstern, die sich eindeutig gegen nackte CDS aussprechen. Vor allem bringt er zusätzliche Beispiele, dass es auch ohne spekulative Motive sinnvoll sein kann, CDS zu kaufen, ohne den Basiswert zu besitzen:

Of course, there are lots of very good fundamental reasons why people might want to buy credit protection on Greece without owning underlying bonds. Maybe you are or will be owed money by an arm of the Greek government. Maybe you have businesses in Greece, and are worried that in the event of a default you won’t be able to repatriate your profits there. Maybe you intend to enter into a contract with a Greek company who you trust and understand, but want to hedge sovereign risk which is out of that company’s control. These are not “purely speculative gambles”, they’re ways of facilitating capital flows into Greece.

Im Grunde sprechen für nackte CDS auch die Argumente, die generell für die Existenz von Derivate- und Terminmärkten vorgebracht werden: Sie ermöglichen die Absicherung von Geschäften für realwirtschaftliche Akteure, und Spekulaten sind auf diesen Märkten wertvolle Marktteilnehmer, weil sie für Liquidität sorgen, und Risiken übernehmen.

# FT Alphaville kreiert den Weltuntergangsindex

Nach der Bekanntgabe der letzten amerikanischen Liquiditäts, Bankenrettungs- und Konjunkturpläne sind erwartungsgemäß die CDS-Spreads für amerikanische Staatsanleihen, also die Kreditversicherungsraten für die US-Regierung, angestiegen. Dieser Spread wird auch Armageddon-Index genannt, aus der Überlegung heraus, was passieren müsste, damit die USA den Staatsbankrott erklären müssten, und welche Folgen dies hätte.

Mittlerweile gibt es eine Reihe von US-Unternehmen, deren CDS-Spreads niedriger sind als die der US-Regierung, wie FT Alphaville recherchiert hat:

AT&T Mobility (28bps)
Baxter International (24.5bps)
Campbell Soup (31bps)
Ingersoll Rand (40bps)
Lockheed Martin (30bps)
McDonalds (29.5bps)
Wyeth (35bps)

Also Unternehmen, die Medikamente, billige Lebensmittel, Waffen und Blutdrucksenker herstellen – womit sich der Kreis zu den Armageddon-Trades schließt. Und Market Watch hat 7 Szenarien aufgestellt, die zur Realisierung des Risiko führen könnten.