CDS Factors In Equity Valuation - Part C

This is the third in a series. Parts A and B were posted on Sep. 10 and 12, 2007 and should be read in conjunction.
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Part C: CDS Pricing and Implications

We have seen in Parts A and B that CDSs create phantom equity exposure and that their notional amounts have soared to $45.5 trillion as of June 2007, approximately 80% of global equity market capitalization (the chart below updates that appearing in Part B). In this post I shall examine the pricing of CDS and the implications for equity markets.

Data: ISDA and World Fed. of Exchanges

There are several indices that track corporate CDS: for US corporations the banchmarks are Markit's CDX Investment Grade (CDX IG) and CDX High Yield Indexes (CDX HY). For Europe, the equivalents are iTraxx Europe and iTraxx Crossover. Below are longer- and shorter-term charts for these indices.

Source: Bank for International Settlements (BIS)

Quarterly Review - 9/2007

The shorter-term CDX charts are provided below; the equivalent for iTraxx look almost exactly the same and in the interest of less clutter they are omitted.

CDX Investment Grade (USA)

CDX High Yield (USA)

Source: Markit

As we saw in Part B, CDS pricing is a reflection of the price of the "phantom" shares created by the multiple issuance of CDS and is thus directly correlated to the equity risk premium (RPi) that was presented in Part A. In other words, RPi is a function of CDS risk, expressed as interest rate spreads.

Therefore, from Part A, the price-to-earnings ratio for shares is expressed as:

PE = 1/(RPi + Real Yield) (Equation 3)

We can separate the risk premium RPi into two components:

RPi= RPih - RPic (Equation 4)

where:

RPih = the value of RPi calculated without the effect of CDS, e.g. as was before CDS amounts took off.

RPic = that portion of equity risk premium that is included in CDSs and which is now trading separately in the OTC credit default market.

This means that the current Risk Premium in the cash equity market appears lower than was the case just 2-3 years ago, leading to higher cash equity valuations, all other things equal.

The creation of CDSs transferred a portion of equity risk from the stock market to the CDS market. Given that, at least theoretically, the total equity risk premium should remain the same, we reach the conclusion that, where sizable CDS markets exist, we can no longer view equity pricing in isolation but must also take into account the CDS market.

This is no easy task for the general public: the CDS market is OTC and dominated by just a handful of market-makers. As of the second quarter of 2007, within the commercial bank universe overseen by the Office of The Comptroller of the Currency (OCC) there were approximately $12 trillion notional CDS outstanding, one third of world-wide total at the time. Five banks held 100% of these positions, with three holding 91%. These figures do not include investment banks, who are also very active in CDS, but provide an accurate view to the concentration within this market.

For the most part, the CDS market is opaque to the general public, though the creation of the CDX and iTraxx indices has helped provide information about the broader credit default market. Even so, the indices also have a small number of market makers (e.g. 16 for CDX). Again, just a few out of this number account for the majority of pricing and transaction volumes.

There are significant consequences to having the equity risk premium trading in two parts. Because of the explosion in CDS notional amounts and daily volumes, the part of a stock's "value" that is trading in the unregulated CDS market is growing in size. How much that is, is beyond the scope of a mere blog posting and is more properly a matter for further study by academia (if it isn't already).

From the perspective of a market participant, however, I have the following closing observations:

1. It is possible that equity portfolio investors are still disregarding the effects of the CDS market in pricing shares. This would lead to higher, but erroneous, theoretical valuations (P/E's) for shares in the stock market.
   
2. Equity underwriters and exchanges are heavily regulated in order to safeguard the public interest. By contrast, the CDS market is largely unregulated, even though it clearly "issues" and trades phantom equity equivalents in a large primary and secondary market . Unlike regulated derivatives markets (e.g. for listed index futures and options), there are no reporting requirements, no position limits and no uniform margin regulations for CDS.
   
3. The small number of major CDS market-makers raises questions about dominant positions and their effects on cash equity markets.
   

This is a work in progress. I am not an academic, so there are clearly gaping holes in the above analysis. For example, CDSs could also be priced as put options - what does this mean for the equity market? If any reader has suggestions on any of the above, please be so kind as to leave a comment or two, which could be included in a possible Part D. I thank you in advance.

In closing, though I have drawn some overall conclusions about the equity/CDS price relationship which I believe are valid, I have not been able to come up with a mechanism to quantify the effect, e.g. how many S&P 500 "points" are trading separately in the CDS market? The quest continues...