loic sarton

1. Risk Management of Financial Institution (
part 1)
Philippe Grégoire
Luc Henrard
Credit
Default
Swap
“Are you advocating a ban on the holding of
open position of CDS related to sovereign
counterparties?”.
Mathieu Philippe, Loïc Sarton and Cédric Percy

2. Recovery
CDS Premium
“Are you advocating a ban on the holding of open position of CDS
related to sovereign counterparties?”
Introduction :
Credit default swap are subject of considerable analysis. On one hand, they seems like a high liquid
derivative product that serve for securization of our bond or others debt. In addition, it help some
financial institution to make loans they would not otherwise be able to make.1
On the other one, a lot of observers and analysis have pointed out the role of the CDS in the financial
crisis. Searching the internet on Google, a search under “worst wall street invention” come up with
the credit default swap as the first entry.2
Many risk managers and hedge fund manager want to ban the CDS. “Are you advocating a ban on the
holding of open position of CDS related to sovereign counterparties?”. This report will put light off
this question, first this report will describe the processes of the CDS then we will see what was the
role of the CDS in the present crisis. In the third part, we will come-up with PRO’s and CON’s of the
CDS. Finally we will end this report by given a response of the previous question.
Mechanism of Dredit Default Swap
The CDS is a bilateral contract between two parties : the seller and the buyer. The Buyer pay a fees
call premium to the seller. Thus if the underlying asset goes into default the buyer will receive a
payoff, the payoff depend of the recovery rate, an obligation can be reimbursed for 50% so the seller
have to pay the other 50% . Such mechanism allow company to reduce their capital thank to the risk
weighting asset in the Basel II regulation. But the cost of the premium depend on the quality of the
reference entities.
What is an “open position”
Any investment that has been entered but not closed. The fact that we held CDS without the
underlying asset ( loan, obligation) so we have an open position, it mean that we are expose to the
market risk.
PRO's and CON's
First he CDS are Off-balance sheet activities so it’s difficult for the market participant to have an idea
of the size of a such market. The basel II regulation have open an arbitrage opportunity that caused
an excessive off-bakance sheet leverage.
1
STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis,Journal of Economic Perspectives - Volume 24,
Number 1. p.1
2
STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis,Journal of Economic Perspectives - Volume 24,
Number 1. p.1
Buyer portection
(Short credit risk)
Seller of protection
(Long credit risk)

3. Secondly the banker didn’t fully understand the risk of such new complex product as the CDO. This
lack of understanding and transparency lead to bad risk managing. Eg: the seller of CDS insure
product that they don’t really know what was behind this CDO, they had an over reliance on the
external rating.
CDS allowed some smaller companies and non-financial institution to issue bond, because these
bond was covered by protection, in addition it has a positive impact on the liquidity in the bond
market. On the other hand, the companies that included CDS indices must face higher bond yield
spread than the other one.
CDS isn’t really a new product, like other derivatives products it appeared 20 years ago, no one really
paid attention of the importance this market take and the fact that it hide the financial risks.
Moreover, these products can lead to increased volatility and market overreaction, hence these
characteristics probably accelerate the crisis.
The CDS market is an Over The Counter market, in other word there is not standardized product, the
two part decide of the specificities of the contract. This market was too big to be not organized and
he was unregulated. The macroeconomic aspect was hidden but it violently come in September
2008.
Some argues that CDS is not only an protection instrument but it become a real speculation
instrument.
“Particulars problems can arise with naked short selling and CDS.Many jurisdictions are moving to
ban or seriously limited naked instruments. When Greece had problems, investor rushed to buy CDS,
including investors who didn’t own Greek bonds, but who would get paid in the event of a default.
Greater demand for CDS means higher price for this form of insurance, making the bonds seem
riskier, so forcing higher interest rate on the government and hurting the economy”i3
Some argues that the CDS like other derivative product only put light off the weakness of several
companies or countries. Only reflected the real value of this bond thank to a more liquid bond
market.
At the start of the CDS, it was promote as an instrument which will disperse the risk but in reality it
has done the opposing effect. A major part of the risk was concentered to organism who accept to
buy risk such as AIG insurance. Finally it was the money of the American taxpayer which was used.
This system is mainly based on external ratings, which have made terrible mistake in the perception
of the risk.
3
uropeanParliament (08-02-2011)
http://www.europarl.europa.eu/news/en/headlines/content/20110204STO13204/html/Short-selling-banking-
on-others%27-misfortune-or-just-hedging-bets

4. Evolution of the CDS and impact of the sovereign debt
This graph gives an illustration of the cost of insuring sovereign debt against default. End 2008, the
subprime crisis cause an increase of the CDS of countries with bad quality debt. Because of this there
was an increase too in the return such countries has to give to have financial resources and it
accelerate the sovereign debt crisis. As we can see in the begins of 2010 there was a double dip due
to the fears of some European sovereign debt. The CDS accelerate the fall down of the value Greek
debt because of the big number of CDS buy for this countries.
Role of CDS in the crisis
From an insurance tool to a speculative tool…
In 2007, just before the financial crisis, the notional value of the CDS market was about 62 trillion
USD whereas the total value of the assets insured was about 5 trillion USD4. We can easily
understand that 80% of CDS investments were purely speculative and became, at first sight, an
“efficient” tool for banks to make billions.
AIG Insurance sold alone around 500 billion USD. However, on September 2008, the FED had to make
an enormous loan of 85 billion USD to AIG in order to avoid its bankruptcy…
For the financial crisis of 2008, four roles played by CDS have been highlighted5;
a) CDS created ambiguity about who eventually bears credit risk
b) CDS enhanced the systemic risk by making the principal CDS sellers (AIG,…) mutually
vulnerable
4
DEMIRGUC-KUNT A., EVANOFF D., KAUFMAN G. (2011). The International Financial Crisis: Have the rules of
Finance Changed ?, World Scientific, p.374
5
McGrawHill Company (2008).http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf (
consulted on 05-11)

5. c) CDS fostered CDS sellers to assume risks
d) CDS accelerated and played a role in economic cycles by its pro-cyclicality
Moreover, as we have previously seen, banks have largely used CDS in order to mitigate their
regulatory capital requirement. This has led to an important increase in the leverage of banks (huge
balance sheet) and thus, in the exposure they had.
Indeed, Yale economist has observed that “the financial crisis and recession (…) has been more
violent because of the creation of the derivative credit default swap market for mortgages in 2005,
just at the top of the leverage cycle”6
We are going to introduce now the role of CDS during the sovereign debt crisis.
Since the beginning of 2010, the debt crisis in Europe has dramatically increased with fears and panic
of a real collapse of several European countries (Portugal Ireland Greece Spain (PIGS)). This crisis has
led to significant spreads of government bond yields and sovereign CDS. “The speculation with naked
CDS (…) is criticized for the turbulence in the European bond market.”7
As a result, in may 2010,
Germany banned naked CDS based on euro-denominated sovereign bonds. Nevertheless, CDS
continued to skyrocket after the prohibition of naked positions within the Eurozone. This pointed out
the panic of market participants toward the viability of these countries. However, there has been a
bright side; Indeed, the ban of these naked sales has brought more stability (or at least less volatility)
within the CDS market8
.
Conclusion
Our answer to the question is yes. We think that we should ban all speculative instrument relative to
sovereign debt because countries are not like companies. The consequence of the bankruptcy of a
country is much bigger than for a company. And according to a lot of survey and analysis speculative
instrument increase the probability of default of a country or company.
Nevertheless it give a good view of the financial health of a country. In addition, It put political on
pressure to take real measure to cope with their debt issues.
We think that we must standardized CDS this could lead to several benefit: It would improve
transparency and reporting of positions boost confidence and avoid panic, it would allow the
supervision of the clearing house and to limit the size of this market.
6
Geanakoplis J. (2009) Solving the Present Crisis and Managing the Leverage Cycle, Yale University, p.49
7
XIAOLING PU, JIANING ZHANG (2012), Sovereign CDS Spreads, Volatility, and Liquidity : Evidence from 2010
German Short Sale Ban,The Financial Review 47 (2012) 171-197, p173-174
8
Ibidem

6. Bibliography
STULZ, R.M. (2010). Credit Default Swaps and the Credit Crisis,Journal of Economic Perspectives -
Volume 24, Number 1.
EUROPEAN PARLIAMENT (08-02-2011)
http://www.europarl.europa.eu/news/en/headlines/content/20110204STO13204/html/Short-selling-
banking-on-others%27-misfortune-or-just-hedging-bets (consulted on 05/10)
DEMIRGUC-KUNT A., EVANOFF D., KAUFMAN G. (2011). The International Financial Crisis: Have the
rules of Finance Changed ?, World Scientific, p.374
McGrawHill Company (2008).http://www.mhhe.com/economics/cecchetti/Cecchetti2_Ch09_CDS.pdf
( consulted on 05-11)
Geanakoplis J. (2009) Solving the Present Crisis and Managing the Leverage Cycle, Yale University
ILHYOCK SHIMY/HAIBIN ZHUHTTP (2010) :twistedeconotwist.wordpress.com/2010/12/02/the-pros-
cons-of-credit-default-swaps/(consulted on 05-10)
http://www.professeurforex.com/analyse-fondamentale-professeur-forex/dossier-analyse-
fondamentale-forex/les-cds-credit-default-swaps/ (consulted on 10-05)
XIAOLING PU, JIANING ZHANG (2012), Sovereign CDS Spreads, Volatility, and Liquidity : Evidence from
2010 German Short Sale Ban,The Financial Review 47 (2012) 171-197