Wolf!!

The discussion about Credit Default Swaps is replete with allusions, examples and (over-)simplifications.  The most frequently used is that CDS is akin to buying fire insurance on a neighbor's house and thus having every incentive to see it burn down.  

But this misses a crucial point: derivatives traders rarely, if ever, want to "take delivery", or execute the futures contract, option, swap, etc.  Instead, they want to make a quick killing on the going market price, i.e. by  trading fire insurance as much as possible instead of seeing the house burn down and collecting on it.  If you want another allusion from Sudden Debt's misty past, they want to trade the "sardine", instead of eating it. 


To wit, it is a fact that the vast majority of futures and many other derivatives contracts are closed out before delivery date, and that most options expire worthless.  Likewise, the vast majority of CDS traders/speculators/hedgers have next to zero desire to deliver (or take delivery of ) the underlying bonds, but , instead, to profit from the market's swings during the time they hold the contract.  

Furthermore, I can tell you from long and relevant experience that the line separating a hedger from a speculator is so thin as to be practically invisible in most cases.  For example, an investor holding a portfolio of bonds comes to the conclusion that credit conditions are worsening and hedges by buying CDS.  Her portfolio now consists of two "legs": bonds and the CDS hedge.  Naturally, the cost of buying and holding a credit hedge reduces her current return close to a risk-free equivalent (say, a U.S. Treasury).  However, this is as near to anathema for active portfolio managers as it gets and that's when trouble starts.  (Why would you pay a manager anything from 0.2% to 2% p.a. just to hold a risk-free asset?)  So, before long, she gets itchy to lift one of the legs, i.e. go net long or net short, no matter what she may preach about prudence and hedging.  It's human nature - and that's what makes markets swing.


Anyway, back to the main story.  The relevant parable for CDS is The Boy Who Cried Wolf (But Didn't Himself Own Any Sheep).  The boy in question is bent upon terrorizing other shepherds because he has shorted mutton meat at the town market and wants to see the shepherds unload their sheep as fast as possible before the "wolf" gets 'em, thus driving down the price.  He has been known to occasionally don a fresh wolf-skin over his body on certain nights and howl to the moon...