Credit-Default Swaps Are Misleading Indicators for Investors
Despite the fundamental financial differences between European countries, credit-default swaps, commonly known as CDS, tend to move in the same direction. Why do CDS premiums evolve similarly? IESE Prof. Miguel Antón, along with Sergio Mayordomo and María Rodríguez of the University of Navarra, have concluded that dealers have much to do with this phenomenon. Thus, CDS do not always reflect countries’ financial health.
Their article, "Dealing with Dealers: Sovereign CDS Co-movements in Europe," has been awarded the UAM-Accenture’s Chair in Economics and Management of Innovation prize for 2013.
A financial Insurance
Created in the mid-1990s, credit-default swaps are a form of insurance that bondholders buy to protect against the nonpayment of their securities. In 2007 these insurances reached a trading volume of $62 trillion thanks in part to the possibility of acquiring them without having to buy the underlying bond.
The daily credit-default-swap prices followed by the general public are a compilation of the daily quotes offered by dealers. Notably, over 90 percent of the quotes come from a small group of about 30 brokers.
Synched Changes between CDS’ Prices
To show the influence of these dealers, the authors connect pairs of countries based on the number of dealers that they have in common. This enables demonstrating that dealer commonality significantly predicts the co-movement of swap premiums for these pairs of countries.
Hence, the investigation shows the relation between the evolution of two countries' CDS and the activity of dealers in those states. For instance, if there was a dealer who frequently and simultaneously reported prices for Spain and Italy, the CDS’ premiums of these countries would move in the same direction and resemble one another since prices would be determined by the same dealer.
Despite the fact that swap premiums are often used as indicators of countries’ financial health and influence the decisions of domestic and international investors, this study reveals that they are not reliable.
And, what’s more: greater transparency and a centralized credit-default-swap market could have helped swap prices better reflect actual risk profiles and reduced the financial contagion level between markets during the recent crisis.
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