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research How Dangerous Are Credit Default Swaps? WITH A DEBT CRISIS looming in Europe, the risk of credit default swaps (CDSs) has taken center stage in finance research. Invented by banks in the late 1990s, CDSs are insurance policies that banks sell to inves- tors to protect them against default. If a CDS-protected investment goes under, the investor is reimbursed by the bank that sold the swap. Another form of the practice is the so-called "naked CDS," in which the buyer does not own the debt in question. Many CDSs are linked to sover- eign bonds. Now that several coun- tries in economic straits are threat- ening to default on those bonds, the issue is of particular interest. Two recent working papers—from Dominic O'Kane researchers at Stanford Graduate School of Business in the United States and EDHEC Business School in France—offer different takes on the complex relation- ship between CDSs and sovereign bond markets. Swaps aren't to blame. Dominic O'Kane, affiliated professor of finance at the EDHEC-Risk Institute in Nice, analyzes the relationship between the price of sovereign- linked CDSs and the decline of sovereign bond markets during the eurozone debt crisis of 2009–2011. O'Kane's research was driven by the fact that some European policy makers believe that the specula- tive use of naked CDSs was a primary driver of the precipitous drop in bond value in Portugal, Ireland, Italy, Greece, and Spain during the eurozone debt crisis. However, O'Kane finds that CDS spreads (the premium buyers pay to sellers) do not drive sovereign bond spreads (the difference between the value of a country's issued bond against the value of AAA-rated bonds) in all cases. In fact, O'Kane finds that in some countries, under some circumstances, CDS prices have the opposite effect. For instance, he discovered that while CDS prices rose higher before bond value declined in Greece, the reverse was true in France and Italy. In Portugal and Ireland, prices moved simultaneously. "CDS spreads are a cleaner and more transparent measure of market-perceived credit than bonds, since 48 July/August 2012 BizEd CDSs are not limited by supply, are as easy to buy as to sell, and have a lower cost of entry," says O'Kane. "If the difference between the CDS and bond spreads becomes too large, market participants will execute trades that will cause the CDS and bond spreads to come back into line." He also notes that the most liquid eurozone-linked sovereign CDSs are denomi- nated in U.S. dollars, while the underlying bonds being protected are denominated in euros. This introduces a currency effect into the relationship between these CDS spreads and bond spreads. "If the market anticipates that the euro will fall in value following a sovereign default, the cost of buy- ing CDS protection in dollars will be higher than the cost assuming no currency impact," he says. As the credit quality of a sovereign declines, the CDS spread must increase more quickly than the bond spread, he explains—not by specula- tors, as some academic studies have suggested. Darrell Duffie When CDS spreads in Greece widened by more than bond spreads in 2010, CDSs came under fire. O'Kane argues that the CDS market simply may have been a better predictor of Greece's default than the bond market, not its cause. Should governments ban naked CDSs, he adds, they would be eliminating an important risk mitigation tool from the market. "The Link Between Eurozone Sovereign Debt and CDS Prices" is available at docs.edhec-risk.com/ mrk/000000/Press/EDHEC-Risk_Working_Paper_Link_ Sovereign_Debt_CDS.pdf. The model needs to change. Two Stanford research- ers agree with O'Kane that CDSs are important tools for JOHN SMITH/GLOW IMAGES