Category: Interesting External Papers

Interesting External Papers

Credit Default Swaps: Links to Primers

Credit default swaps have been in the news quite a bit lately, so I’m posting some links to articles:

Credit Default Swap (CDS) Primer, Nomura, May 2004

The CDS Market: A Primer, Deutsche Bank, 2004

Bloomberg article on Insider Trading (hat tip Bill Cara) Note: it’s not clear to me why these changes in the CDS levels did not leak into the bond market via arbitrage of the basis.

Update, 2007-7-29: There’s a good introduction at the Accrued Interest blog.

Update, 2007-9-13: There are some good downloadable papers at John Hull’s website. Hull & White, 2000 is the basis for the Bloomberg CDSW screen.

Update, 2008-01-28: Hu & Black discuss the problems inherent in “debt decoupling” – if the owner of a bond is fully, or even more than fully, hedged via CDSs, this block of bonds might be voted in a manner that is predjudicial to the economic interest of that class of creditors.

There are also several sources of qualitative evidence. One is the recent tendency for credit default swap contracts to require the protection buyer, if it is also a creditor, to act in the interests of other creditors. This suggests concern that the protection buyer might not otherwise do so. How this obligation can be enforced, however, without disclosure of either votes or hedges, is anyone’s guess. We have also heard from bankruptcy judges that they sometimes see odd behavior in their courtrooms, which empty crediting might explain. For example, one judge described a case in which a junior creditor complained that the firm’s value was too high, even though a lower value would hurt the class of debt the creditor ostensibly held.

There is some commentary at Naked Capitalism.

Update, 2008-2-6: More warnings via Naked CapitalismCDSs may not work as advertised due to operational issues, the ascendency of Sales over Risk Management, and the relative amounts of notional vs. deliverable bonds.

Update, 2008-3-30: Another risk with CDSs is a potential disparity between the cash-settlement price and the ultimate recovery price, as has happened with Delphi. See AleaBlog and Felix Salmon.

Update, 2008-4-3: It’s linked in the comments, but I should highlight the February 21 review of some BoC Research into CDS Pricing.

Update, 2008-9-4: See also CDS Recovery Locks.

Update, 2009-3-12: Risk Weight of Credit Default Swaps.

Interesting External Papers

The Bond Market is Excitable

Prof. Hamilton at Econbrowser commented on a speech by Bernanke in which variability of inflation expectations was discussed. JDH went on to reference a very good academic paper, The Excess Sensitivity of Long-Term Interest Rates: Evidence and Implications for Macroeconomic Models in which these effects are quantified.

Of course, that paper is nearly four years old now. In the interim, there have been expressions of regret for the disappearance of bond market vigilantes; this apparent disappearance is probably due also to indiscrimate buying by the Chinese as much as anything else. Also, probably, due to the fact that idiots such as myself, who have been saying for years that inflation of 2%-ish should mean Canadian 10-year-yields of 4.75-5.25%-ish have had our heads handed to us on a 3.75% plate.

Anyway, the paper is a good one. Abstract:

This paper demonstrates that long-term forward interest rates in the U.S. often react considerably to surprises in macroeconomic data releases and monetary policy announcements. This behavior is inconsistent with the assumption of many macroeconomic models that the long-run properties of the economy are time-invariant and perfectly known by all economic agents. Under those conditions, the shocks we consider would have only transitory effects on short-term interest rates, and hence would not generate large responses in forward rates. Our empirical findings suggest that private agents adjust their expectations of the long-run inflation rate in response to macroeconomic and monetary policy surprises. Consistent with our hypothesis, forward rates derived from inflation-indexed Treasury debt show little sensitivity to these shocks, indicating that the response of nominal forward rates is mostly driven by inflation compensation. In addition, we find that in the U.K., where the long-run inflation target is known by the private sector, long-term forward rates have not demonstrated excess sensitivity since the Bank of England achieved independence in mid-1997. We present an alternative model in which agents’ perceptions of long-run inflation are not completely anchored, which fits all of our empirical results.

Interesting External Papers

External Paper: Chinese Effect on US Interest Rates

I can’t stand it any more! I read something interesting on the Internet and then have trouble finding it later! So from now on, I’m going to keep a list: International Capital Flows and U.S. Interest Rates, Francis E. Warnock, Veronica Cacdac Warnock.

Abstract: Foreign flows have an economically large and statistically significant impact on longterm interest rates. Controlling for various macroeconomic factors we estimate that had there been no foreign flows into U.S. bonds over the past year, the 10-year Treasury yield would currently be 150 basis points higher; even a step-down to average inflows would imply an increase of 105 basis points. The impact of the headline-making foreign official flows—a relatively small subset of total foreign accumulation of U.S. bonds—is also significant but markedly smaller. Our results are robust to a number of alternative specifications.