CDS Price Volatility Shows The Limits Of Regulation [Study]
- Clay Westbrook
- Jan 5, 2015
- 3 min read
Here’s an example of a “credit derivative” that we hope everyone can understand, based on an almost-true story.
Someone purchased jewelry for $10,000. The jeweler will take a return at any time and will issue a store credit for the original purchase price. The jewelry has declined in value, and If the buyer sold for cash, he could get $5,000 for it.
Meanwhile, the person’s friend has great news, he is getting engaged. He NEEDS to buy jewelry. How does everyone win?
The buyer returns the jewelry and gets the $10,000 store credit, and then sells the store credit to the friend for $7,500. The friend marches into the store and buys a $15,000 ring. Thanks to the credit, he pays only $5,000.
Thus, I have $2,500 more in my pocket than if I sold the jewelry, and my friend saves $2,500 on the ring.
So the obvious question is (other than “what the heck does this have to do with derivatives?”) is why did we not buy $10,000 worth of jewelry with the credit and sell it for $10,000? BECAUSE WE ARE NOT IN THE JEWELRY BUSINESS. The jeweler is in the business and knows where to go to get the best wholesale price.
A derivative is a financial asset that is based upon the underlying value of a tangible asset, another financial asset, or, incredibly, another derivative asset. In this example, the derivative is the store credit, the jeweler is the issuer, and the buyer is the counterparty. The store credit is based upon the value of the underlying asset, the jewelry. Because we are not in the jewelry business, I am willing to sell the derivative at a discount in order to get cash, and fortunately there is a willing buyer in the friend. The transaction with the buyer we will call “the secondary market."
The holder of the store credit runs the risk of the jeweler going out of business, making his store credit worthless. The jeweler runs the risk of so many people redeeming store credits at once that he doesn’t have the assets (jewelry and cash to buy more jewelry) to honor the credits. However, if the holders of the store credits see lots of other holders redeeming credits, they will rush to the store to get theirs, too, for fear that the jeweler goes out of business.
Furthermore, let’s say that the fellow getting engaged learns on CNBC that the jeweler’s business is in trouble. He won’t pay as much for the credit because he is assuming greater risk of loss. And because there are no other buyers, and the seller isn't in the jewelry business, the seller sells for even less than the value of the underlying jewelry in order to get cash. Then when the transaction is reported on Bloomberg, the store credit market craters, more and more people rush to redeem their credits, and the value of the credits goes down further as a result.
Now imagine that only 5 jewelry stores control half the world market. You read in Investors Business Daily about the big problems that Jewelry Store A is having. You take a sip of your Cappuccino and congratulate yourself “thank goodness I’m safe, because my credit is with Jewelry Store B.”
You go that afternoon to sell your store credit on the open market, and it’s only worth 90 cents on the dollar?
“What gives, this is Store B credit, not A!”
“Well, we figure that if A has problems we know about, B probably has problems we don’t know about yet. Also, many of B’s customers also do a lot of business with A and have lost a lot of wealth because of A’s problems. Demand for jewelry has also gone down because buyers can’t be sure a store credit will be worth anything, lowering the value of the underlying assets and adding to the risk.”
Of course, one of the big differences between the jewelry stores and the derivative market is that in our example, most of Jeweler A’s store credits would be held by Jeweler B, and most of B’s store credits are held by Jeweler C, etc.
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