Sunday, December 12, 2010

Counterparty risk and contract volumes in the credit default swap market (BIS)

by Nicholas Vause

Abstract: After more than a decade of rapid growth, the volume of outstanding credit default swaps peaked at almost $60 trillion at the end of 2007. Since then it has nearly halved, while turnover has continued to rise. The decline in volumes outstanding reflects intensified efforts to reduce counterparty risk, which have eliminated more than $65 trillion of offsetting positions.

Download here: www.bis.org/publ/qtrpdf/r_qt1012g.htm

Tuesday, December 7, 2010

The Inefficiency of Clearing Mandates (Craig Pirrong)

Abstract: In the aftermath of the financial crisis, attention has turned to reducing systemic risk in the derivatives markets. Much of this attention has focused on counterparty risk in the over-the-counter market, where trades are bilaterally executed between dealers and derivative purchasers. One proposal for addressing such counterparty risk is to mandate the trading of derivatives over a centralized clearinghouse. This paper lays out the advantages and risks to a mandated clearing requirement, showing how, in some instances, such a mandate can actually increase systemic risk and result in more financial bailouts.

This paper also describes the dynamics of counterparty risk in the derivatives market. Discussing the relative importance of both the risk that arises from the price risk of the instrument at issue and the financial condition of the counterparty. The analysis then turns to an evaluation of how bilateral markets and clearinghouses manage these two risks. After demonstrating that resolving and replacing defaulted trades is the primary resolution problem facing both market structures, the paper lays out an auction alternative designed to address this issue.

Download here: papers.ssrn.com/sol3/papers.cfm?abstract_id=1710802

Thursday, December 2, 2010

An Analysis of Euro Area Sovereign CDS and their Relation with Government Bonds

by Alessandro Fontana, and Martin Scheicher
ECB Working Paper No. 1271

Abstract: This paper studies the relative pricing of euro area sovereign CDS and the underlying government bonds. Our sample comprises weekly CDS and bond spreads of ten euro area countries for the period from January 2006 to June 2010. We first compare the determinants of CDS spreads and bond spreads and test how the crisis has affected market pricing. Then we analyse the ‘basis’ between CDS spreads and bond spreads and which factors drive pricing differences between the two markets. Our first main finding is that the recent repricing of sovereign credit risk in the CDS market seems mostly due to common factors. Second, since September 2008, CDS spreads have on average exceeded bond spreads, which may have been due to ‘flight to liquidity’ effects and limits to arbitrage. Third, since September 2008, market integration for bonds and CDS varies across countries: In half of the sample countries, price discovery takes place in the CDS market and in the other half, price discovery is observed in the bond market.

Download here: www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1271.pdf

The impact of CDS trading on the bond market: evidence from Asia

by Ilhyock Shim and Haibin Zhu
BIS Working Papers No 332

Abstract: This paper investigates the impact of CDS trading on the development of the bond market in Asia. In general, CDS trading has lowered the cost of issuing bonds and enhanced the liquidity in the bond market. The positive impact is stronger for smaller firms, non-financial firms and those firms with higher liquidity in the CDS market. These empirical findings support the diversification and information hypotheses in the literature. Nevertheless, CDS trading has also introduced a new source of risk. There is strong evidence that, at the peak of the recent global financial crisis, those firms included in CDS indices faced higher bond yield spreads than those not included.

Download here: www.bis.org/publ/work332.htm