WM is trading inverted due to jump to default hedging in the front end. Not only is the conditional probability of default greater in the early yrs, but those hedging this name prefer to be in the front end of the curve in order to not be exposed to a longer dated annuity. Any negative liquidity news will continue to invert this curve, but if WM gets taken out, you will see this curve steepen as well due to the better credit quality of the buyer, causing the probabilities of default to shift downward and steepen out the curve. The process of a curve inverted sharply is what I was referring to as “jump to default”.
mib20 Wrote: ------------------------------------------------------- > WM is trading inverted due to jump to default > hedging in the front end. Not only is the > conditional probability of default greater in the > early yrs, but those hedging this name prefer to > be in the front end of the curve in order to not > be exposed to a longer dated annuity. Any > negative liquidity news will continue to invert > this curve, but if WM gets taken out, you will see > this curve steepen as well due to the better > credit quality of the buyer, causing the > probabilities of default to shift downward and > steepen out the curve. The process of a curve > inverted sharply is what I was referring to as > “jump to default”. Any Bankrupt news and this thing trades closer to flat then to inverted. The reason being, if Wamu was not doubt in my mind going to bankrupt in the next 6 months, and it was trading inverted CDS, 1 year 1000 & 10 year 500, I would buy the 10 year, sell the 1 year and postive carry 500bps for 6 months.
i love you guys. learn something everytime i read a new post.
MFE, your carry will be meaningless if the credit does not default. In your case, you will earn your carry for a short time if the credit goes bankrupt and be notional matched so your default exposure is meaningless. However, once your short end long risk position rolls off, you will be exposed to a 9yr short CDS contract. If you really carried about making carry, which in reality, nobody really does, you should just sell $Xmm of 1yr AAA rated CDS and call it a day. In your case, you will suffer mark to mark losses if the curve continues to invert which carries implications far more important than your carry because dealers will begin to ask for large amounts of collateral, making it harder to do future trades. I guess my point is that there is no reason to think that a company on the brink of default will have its curve steepen out. Carry is not that big of a deal by itself and your p/l risk has the ability to crush you way more than your carry.
yes i understand all this mib20, but like i said, if news gets very bad and i think the company WILL default, that’s a trade to put on, thus causing the spread curve to flatten.
Yah, but nobody will care about 6 months of carry. The majority of those in this trade will be hedging bonds through 1yr, so the front end will continue to be bid up, giving you MTM losses if you are long that front end short the back end. There are much better ways to get carry without that much MTM risk. Don’t think any desk will allow you to do that trade in any type of size.
MFE - I can check on monday, as I dont pay much attention to tranches (I don’t trade them either) so don’t know off the top of my head, but 59 pts upfront at 500 running on an IG index sounds really high. Is it really trading there? I am not all that familiar with them and the brief bit that was on the exam has left my head, is the 0-3% tranche the first to absorb losses? It MUST be. Have you seen anyone who has done a good primer on index tranches? I’d like to be more comfortable with them than I am (I know very little). Mib20 - Thanks for the talk about inverted curves, it has intuitively made sense to me in the past, but you put it very well in the context of the reality of putting on trades, etc. I generally follow 5yr levels just to help as a guidepost to cash trading, but your description was a big help. Thanks.
The 5 yr level is the most liquid and the best level to follow, but to make money trading, you will need to know the entire very well. However, from a pure credit standpoint, the 5 yr level will typically be good enough for you to express a view. You are also right that 50 pts up front is way too high. In terms of losses, the 0-3% tranche is the equity tranche of the index and will absorb the first 0-3% losses in the portfolio. Being short this attachment point of the tranche will be very good when correlation is low and idiosyncratic risk is high.
IG 0-3% tranche got as high as 65pts upfront in May05 with GM/F rumored bankrupt news.
Makes sense.
JoeyDVivre Wrote: ------------------------------------------------------- > rohufish Wrote: > -------------------------------------------------- > ----- > > the CFA curriculum barely even scratches the > > surface of credit derivatives unfortunately. > they > > need to fix this issue. > > > > its actually quite astonishing that you can get > a > > CFA with minimal knowledge of the credit side. > > > Not just credit derivatives - freaking credit. I > think you could get a charter and not know the > difference between a AAA bond and a B bond. Credit, perhaps. Credit derivatives? Really? With structured credit having already/about to shrink by 50% across the board? Is this necessary for a group consisting mostly of sell-side analysts, mutual fund analysts and portfolio managers, many of whom are focused on portfolios for moderately HNW individuals?
Someone in the industry can help me out with decent numbers, but I would guess credit derivatives are > $50 Trillion. Sounds pretty important to me.
Come on - that’s a notional value. Remind me again what the gross leverage is on the notional value of a eurodollar option?
Joey, you are right with the >50 trillion notional outstanding number. I always get a kick out of non-credit people and CFA'ers who talk about equity as though it's some be all end all market. The funny thing is that if those in equity actually followed the credit markets closely, the pain that they are feeling right would not nearly be as bad. I'm totally biased, but I really do believe that it will be quite difficult to be fully in touch with the markets without a good grasp on the credit markets. Hell, it has significantly led this equity market correction, and anyone following both markets would have surely seen this relationship forming. On top of that, I would definitely not classify CDS as being a structured credit vehicle, so the comment on the slow down in that product should have no reflection on whether or not CDS is taught in the CFA program. Just my .02.
NakedPuts Wrote: ------------------------------------------------------- > Come on - that’s a notional value. Remind me > again what the gross leverage is on the notional > value of a eurodollar option? So is that a response to a story from me? I do love my stories. Anyway, I used to manage risk on a portfolio of ED options. People would call up and ask me the “leverage” on the portfolio. I would hem and haw until I gave up and then I would tell them number of options owned * $1 million / fee-paying capital in account. Then they would call me psychotic and other bad names. So notional values aren’t created equal. It’s not even clear to me what the “notional” value of a ED futures contract is, although everyone else seems sure it is $1 million. I think that a futures contract on gold is for gold worth 100 oz * some number a lot like the spot price = (say) $93000. A futures contract on ED is on the interest for a quarter on $1M so in the same kinda way as a gold contract the notional size ought to be (say) 4%*1/4*$1M = $10000. And then there’s the option which might be cab (worth less than a tick) which might be worth $3 (i.e., less than the commission for selling it) but its notional size is $1M? So I’ll agree that notional sizes can be very misleading ways of looking at the importance of a market. However, I think the credit derivatives market is very important (the ED futures/options market is obviously very important too) and the notional size is a somewhat relevant number. Confining ourselves to just CDS for a second a) The notional size of the CDS on a particular company is something like the amount of bonds that will need to be delivered when a credit event happens. All the CDS are affected by the same credit event (unlike ED options) and the mismatch between the outstanding amount of CDS and the amount of available bonds is a real issue. b) Outstanding CDS directly affect equity valuation (and other securities) in many cases. For example, in the BSC collapse there were investors who had sold CDS protection who then had enormous interest in the takeover going through. People were buying up shares of BSC at $4 so they could vote to have a takeover go through at $2 so they could protect their CDS position. That’s a new kind of dynamic and exactly the kind of thing that charterholders are supposed to be able to think about better than other people. c) ED futures and options are traded on a regulated exchange with publicly available data. CDS are OTC with an unknown amount of societal risk. We’ve had debates on AF about whether or not CDS increase or ameliorate risk in society (good arguments on both sides, I think) but it seems pretty clear that taxpayers have already eaten a pretty good chunk of credit derivatives disaster. The subprime thing would pale compared to a series of corporate bankruptcies. I think a GM bankruptcy in particular would be exciting to watch in the same way as I enjoyed the Falklands War or something (oh this is horrible, people dying, I’m giving 3:1 and betting on the Brits!). With other credit derivatives like CDO’s a) The model of tranching to distribute risk works. There is an unbelievable mountain of underutilized capital in the world that sits idle because of risk (and other) problems. Whatever we can do to get that going benefits all of us and tranching is part of the puzzle. It would be a terrible shame if we abandoned that because of our recent debacle. b) As with any new securities markets there is a pile of crap out there that needs to be fixed up (like CPDO’s). c) How much wealth has the ED market eaten? (Maybe none, but it has sure facilitated lots of stuff). How much wealth has been destroyed by the uncertainty associated with credit derivatives? Virgin keeps telling everyone that investing in financials is silly because their BS’s are impenetrable. Maybe, but is the world a better place if equity investing in financials makes no sense? I don’t have a solution to this problem but charterholders are supposed to be in the vanguard of suggesting solutions (if we leave it to lawmakers, accountants, or academics we will get solutions we don’t like). d) As MIB points out - didn’t the world just melt down on this stuff and what more evidence would we need of their importance?
Oh - and how did Jackson lose that fight? I was pretty sure it would go the other way…
mib20 Wrote: ------------------------------------------------------- > Joey, you are right with the >50 trillion \> notional outstanding number. I always get a kick \> out of non-credit people and CFA'ers who talk \> about equity as though it's some be all end all \> market. The funny thing is that if those in \> equity actually followed the credit markets \> closely, the pain that they are feeling right \> would not nearly be as bad. I'm totally biased, \> but I really do believe that it will be quite \> difficult to be fully in touch with the markets \> without a good grasp on the credit markets. Hell, \> it has significantly led this equity market \> correction, and anyone following both markets \> would have surely seen this relationship forming. \> On top of that, I would definitely not classify \> CDS as being a structured credit vehicle, so the \> comment on the slow down in that product should \> have no reflection on whether or not CDS is taught \> in the CFA program. Just my .02. Don’t distort my words. I said credit could probably use more coverage. But in this extremely large world of “investment analysis and management”, is more coverage of credit default swaps really what the program could use? At the expense of what? Maybe a little more financial statement analysis and all you credit folks would have known exactly what you were investing in. Also, I know structured credit vehicles aren’t credit derivatives, but it’s fairly surprising you don’t recognize the linkage in those 2 markets.
NakedPuts Wrote: ------------------------------------------------------- > Don’t distort my words. I said credit could > probably use more coverage. But in this extremely > large world of “investment analysis and > management”, is more coverage of credit default > swaps really what the program could use? At the > expense of what? It’s simple to find stuff in the curriculum that ought to be gone for this. First on my list is purchase vs pooling. LIFO vs FIFO accounting. US-centric tax law. GIPS. Breusch-Pagan tests and similar. Obscure ethics questions whose answers change every couple of years. Treynor-Black. > Maybe a little more financial > statement analysis and all you credit folks would > have known exactly what you were investing in. I have never heard anybody suggest that the credit debacle was due to improper financial statement analysis even to a small degree. > Also, I know structured credit vehicles aren’t > credit derivatives, but it’s fairly surprising you > don’t recognize the linkage in those 2 markets. I think there’s lots of linkage and I think the slowdown is and should be temporary. We had a CMO crisis once. They just changed the name and the rules a little and the technology caught up with a good idea.
I recognize the link, CPDO’s and CSO’s were quite improtant, and forced unwinds of these products were big drivers in basis trading earlier in the year. However, even with the fall of structured credit vehicles, CDS are still one of the most important modern tools in the capital markets. When did financial analysis not become important to credit analysis? I’d almost venture to say that without a firm understanding of finanacial statement analysis and valuation, investing in credit is quite risky - especially when it comes down to special situations. I would probably be more inclined to say that credit should be substitiuted in at the expense of a little quant, econ, fin statment analysis, and valuation. Obviously, these are very important topics, but could be trimmed down just a tad for more credit specific topics.
Mib - I agree. While I may not have the best memory in the world, I do not recall virtually anything touching on even the simplest of credit work: looking at leverage, sr vs jr, secured vs unsecured, interest coverage, etc. Aside from looking at liquidity, which was addressed in the context of an equity investor threatened by a liquidity event. There was little in the way of corporate credit curves, cross asset class relative value, etc. I too am biased, but I was disappointed in that. That said, someone could tell me that it is gaining traction, or that I simply missed it. Im not the smartest guy in the world.