Re: A QUERY Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

> From: Tom Gray <tom_gray_grc () yahoo com>
> Date: October 19, 2008 3:57:16 PM EDT
> To: ip <ip () v2 listbox com>, dave () farber net, tom_gray_grc () yahoo com
> Subject: Re: [IP] Re:  must read Credit Default Swap (CDS) question  
> and answer
>
> Prof Farber
>
> I hope that you can post this question to your list. The explanation  
> below discusses the pricing of CDOs and their related CDSs. It  
> mentions an unsurprising result that the price of a derivative is  
> related to the hedge for its risk. So the price of a CDS should be  
> related to the risk inherent in the underlying CDO. This is not a  
> result which will surprise many people. So the question is about the  
> pricing of CDSs on the CDOs for mortgages that were sold to people  
> who had no possibility of paying them off. The only way that these  
> mortgages would work was if the housing market rose without  
> interruption forever. This unlikely assumption has been empirically  
> denied.
>
> So the question is about how the risk of these CDOs ere estimated. I  
> have read that the people holding the CDOs were indifferent to the  
> risk since they had swapped the risk with the sellers of CDSs.
>
> How did these CDS investors assess the risk of these mortgages when  
> they had no relationship with the people paying the mortgages?
>
> The deep mathematics that surrounded these instruments would seem  
> depend on this sort of knowledge and be useless without it
>
> Tom Gray
>
>
> --- On Mon, 10/20/08, David Farber <dave () farber net> wrote:
> From: David Farber <dave () farber net>
> Subject: [IP] Re: must read Credit Default Swap (CDS) question and  
> answer
> To: "ip" <ip () v2 listbox com>
> Date: Monday, October 20, 2008, 12:08 AM
>
>
>
> 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
>
> Archives        
>
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