Wednesday, November 01, 2006

CME to list CDS

The Chicago Mercantile Exchange plans to list futures on credit defaults. It sounds to me as though the process will be similar to a credit-default swap, but will be exchange traded, which should improve liquidity.

A credit-default swap is where one party agrees to pay a fixed payment and in exchange, the other party agrees to buy a reference obligation at par in the event of a default. So let's say you owned some Clear Channel Communications bonds and you wanted to eliminate the credit risk, but for whatever reason, you didn't want to sell the bonds. You sell a credit default swap, and if Clear Channel defaults, you simply sell your bonds to the other party at par. You pay for the protection in the form of a fee, which in practice is similar to the LIBOR spread of a floating-rate bond of the same issuer.

CDS have come to dominate corporate bond trading, because its a cleaner way of achieving credit exposure. Rather than try to find a specific bond, which may or may not be available, you simply short the CDS, which pays you the spread you wanted anyway. CDS can also be more liquid than specific bond issues, which makes it a good place for hedge funds to speculate on movements in the credit market.

If the CME goes through with their program, it would make derivatives trading all the more attractive over cash corporates for large institutional investors. Will anyone actually trade bonds anymore??

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