Re: must read Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

> From: Simon Clift <ssclift () gmail com>
> Date: October 19, 2008 2:14:53 PM EDT
> To: dave () farber net
> Subject: Re: [IP] Credit Default Swap (CDS) question and answer
> Reply-To: ssclift () gmail com
>
> Hi Dave,
>
> At the risk of advertising my scum-of-the-earth status as a quant,  
> here
> goes an explanation of why CDS's should not be banned or set aside.
>
> On Sat, 2008-10-18 at 20:03 -0400, David Farber wrote:
> > From: "David P. Reed" <dpreed () reed com>
> > Date: October 18, 2008 11:39:44 AM EDT
> > Revoking gamblers' lottery tickets?  Nice move, unless the gamblers
> > fund your campaigns, as they do in this case.
>
> Hedge, please, not lottery ticket. :)
>
> Without an instrument which represents a given risk you have two
> problems.  The first is that you have no mechanism for comparing your
> estimate of risk against someone else's.   No publically visible price
> leads to a lack of information in the market.  Second, when you buy an
> instrument like a CDO and think there may be a pricing error (in the
> pricing of risk), or if the market develops in a nasty way, you need
> instruments like CDS's to hedge, or transfer, risk.  No hedge leads to
> inefficiency and costs everyone money.
>
> In theory, this comes down to Debaen and Schachermayer's work
> demonstrating that (and I'm sure I'm butchering this) the existence  
> of a
> unique price for a derivative is equivalent to the existence of a  
> hedge
> for its risk.  A derivative, in theory, trades a risk from someone who
> wants rid of it, to someone who can actively manage it.  The cost of
> management supplies the price.
>
> For example, the recent mortatorium on short selling had an immediate,
> and costly effect on the derivatives market.  The first thing traders
> asked me that morning was "how do we hedge our Puts?", which are
> contracts that pay when prices drop.  Sure enough, the spread between
> bid and ask prices went up and it became more expensive for everyone  
> to
> hedge their risks.  The U.S. government had removed a fundamental  
> market
> mechanism and driven up costs.  Guess who made money? (Hint: not the
> purchasers of derivatives.)
>
> What would be very useful, IMHO, is a better exchange mechanism for
> commonly traded "exotic" derivatives like CDS's.  The backing of the
> exchange would ensure both that prices are visible and that payments  
> are
> guaranteed.  Fortunately, the financial world is tending to move this
> way.
>
> > and lots of "evidence" that "prediction markets" "always work".
>
> There have been a number of studies, actually, indicating that risks
> implied in the market aren't particulary good (or bad) estimates.
> Sometimes you can actually extract the pricing model and coefficients
> that a market participant is using by looking at their quoted prices.
>
> > It's a career limiting move for anyone entering the math side
> > of US economics profession to be skeptical of the idea that price
> > doesn't reflect information perfectly.
>
> The biggest piece of horses**t that goes into any of my models is a
> single estimate of future volatility taken from the market.  My  
> personal
> preference is to attach an estimate of error in valuation inputs then
> get a price range.  That's considerably trickier to do, however, than
> the usual valuation procedures.  On the other hand, since the quoted
> market price is also the price at which you can offload a risk to
> someone else, it is inherently the "correct" price.
>
> -- Simon




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