The CDS market and the fund managers
Interesting speculation from econoblogger Felix Salmon at RGE, here and (later on) here, drawing on our earlier post about the CDS market. He suggests that the reason the long/short equity funds are getting into the CDS market is that they are putting on CDS carry trades - shorting the stock and selling default protection on the debt.
This trade has got a few attractive features: as long as CDS yields stay higher than repo rates, you will make money, and if the underlying name hits trouble, the money you lose on the protection you've sold will be recouped through the equity short.
It's similar to the EDS/CDS carry trade, (pdf, and a technical pdf at that) where you sell equity default swaps and buy credit default swaps on the same underlying name; if everything goes smoothly, you will profit - if there's a credit default, you're hedged. The problem comes if an equity default isn't accompanied by a credit default - which could happen if, say, you were coming into a general market slump, and shares fell enough to trigger the EDS without any credit events.
Salmon's commenters point out that there are problems with the CDS carry trade too. First among them, what happens in an LBO? An LBO means lots more debt, so CDS spreads go up; but it also means the stock rises, so you lose money on your equity short too.
Of course, we don't know if anyone is actually doing these trades - yet. But we're digging deeper on this one...
Any thoughts? Take them to the Risk Forum.


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