Wednesday, October 15, 2008

Fear and Loathing of Derivatives: A Note about CDS


There are a lot of people super-freaked by the multi-trillion dollar figures that are compiled on credit derivative swaps (CDS), the instruments that allow people to ... manage credit risk.

Here is an important fact about derivatives.

For a given set of bonds, in the event of default, the economic loss is limited to the par value of the bonds at the time of default. If the bonds are worth, in total, $328 billion, that's the maximum amount that investors will lose*.

Conceptually, derivatives are risk transfer vehicles. In the world of derivatives, my loss is always someone else's gain, contractually. Systemwide, the gains and losses on contracts are always zero, so that any loss is limited to the value of the underlying.

You may find that hard to swallow. Many people have their passions all worked up over it, so there will be a lot of heat. However, that is the case, unequivocally.


Once you understand that, but not before, you gain insights into how to think about the risks that an individual firm can run, without posing a risk to the whole system. It also helps Ben, as he works to help legislators work out laws that will allow firms with large derivatives operations to ... fail without consequence, in the future.

As I understand it, the people who are paid to do so, the BIS (Bank for International Settlements), imposed capital requirements for credit derivatives and other derivatives, that are not too chumpish. This seems to dispell the notion that these things were ... wholly unregulated.

We have no real data of net exposures by firm, so we see through the tea leaves, only. What we might guess, so far, is that those who were regulated, have done more or less okay. Those who were ... er, "beyond regulation", appear to have multiplied their individual risks.

Note to self and others: the unwatched risks are the ones that always multiply!

*technically, it's still a wealth transfer from lender to borrower

see also: Paging ISDA, New Estimate Please

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