Monday, December 3, 2007

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.

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.

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.

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)


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...


  1. Your idea of linking the growth of the CDS market with the shrinking of the equity risk premium is both interesting & novel. In terms of expressing the interconnectedness of the two, I would express it somewhat differently. Rather than seeing the equity risk premium as a sum of 2 parts: the risk premium before the onset of CDS's and that implicit in CDS's, I would propose the following. View the total equity risk premium as a series of tranches, much like those in a CDO. Namely the debt portion + the pure equity portion. In this case the debt portion is completely covered by CDS. That leaves the pure equity portion as the only amount that is not hedged by CDS. A compression of CDS naturally results in a compression of the whole euity risk premium (and vice versa). This begs the interesing question of today, namely, how come the recent "explosion" of the debt portion of the risk premium (as implied by the CDS market) has not led to an equal or greater rise in the total equity risk premium? Beibng more "risky" than the debt portion, one would expect a greater rise in the pure equity risk premium. In fact, we have witnessed a shrinkage in this recently given that equity markets are broadly unchanged despite the rise in credit spreads. Rationality would call for a large drop in equity prices from today's levels unless "something else" is holding them up. Time will tell as to how powerful this "something else" is.

  2. Dear zeno,

    Thanks for the "tranche" terminology. It really explains my point much better.

    As to why the pure equity risk premium tranche has not adjusted upwards, leading to lower equity prices...I am as much at a loss as you are. Perhaps portfolio managers see lower forward P/Es and think them bargains vs. historical levels because they are not considering the CDS market. So they keep buying/not selling.

    This may continue until the effects of increasing credit defaults start hitting CDS and equity markets at the same time. For example, CDS traders could seek to hedge by shorting stocks at the same time equity traders are selling outright. Double hit..


  3. CDS in mainstream news this morning:

    "CDS trade strategy heaps pressure on US borrows"

  4. Great post. Can tell you major CDS broker is employing a swap strategy that uses CDS as a leading indicator for equity prices presently.. One theory on explosion of debt premium is that the debt market is overplaying its hand and the equity market continues to hang on to the global growth thesis will solve all rights. spoke to A CDS trader this weekend at a major shop and the conversation reminded me of one with Goldman internal risk director: hands in the air and something like " this will end badly."

  5. zeno - are you saying that CDS's are supporting debt market, which in turn makes equity market appear safer than it is? (because CDS's themselves aren't safe?)

    Hellasious - could a CDS be viewed as a $0 put in relation to equity market cap of a particular company? The insurer would be the seller of the put in this scenario.

    If this is the case, then wouldn't this mean, at the very least, that the equity market was leveraged many more times than is currently acknowledged or measured by margin, options, and futures markets?

  6. Are you taking in to consideration that as a derivative (OTC) a CDS can be double or sometimes Tripple counted ? If A buy protection on z from B, that subsequently buys protection on the same z from C, that on a later occasion buys protection from A, what you have is a NET Exposure of ZERO, very much like in the Forward Market for FX. If say, the notional was USD 10mm, which is a good proxy for single name transactions, you would have USD 30mm in CDS accounted for, that excentially has no effect whatsoever, because when and if z defaulst, the subsequent cash-flows will cancell each other. It is true however, that the growth in CDS alloed for greater supply of credit and risk taking. But it also allows for easier spreading of risks. As it makes credit risk "Transportable".

  7. re: Amatuer 20% p.a,

    exactly, this is why total notional outstanding is not particularly meaningful. when outsiders to the cds market see "total exposure grew 110% this year to $45.5 trillion" it is very easy to be fearful of it, but it is NOT the same as, say, mortgage LENDING soaring to crazy levels...derivative trades will cancel out everywhere.

    For example, I probably have, at a total guess, maybe $50bn-$100bn of live CDS trades in my book just now, but my overall risk is fairly flat.

  8. and karen, re: that reuters article you posted that claims the cds market is pushing up financing costs for companies, this argument holds no is the same dumb logic that cr*ppy companies use when they blame short sellers for a weak share price.

    The market is what the market is...the combined view of thousands of participants (yes, EVEN the credit markets!)...if the prices were "wrong", any of those people could go in to correct it.

  9. and hellasious, you are on to something with the link between the credit and equity markets, though personally i think the best way to look at it is HOW you discount the equity cashflows.

    So similar-ish to your logic, the way to discount the projected cash-flows for any company should be by the risk-free rate PLUS the cds premium. Us CDS pro's have our spreadsheets set up to calculate discount factors exactly, but roughly it works by:

    1) using the LIBOR/Swap curve as the "risk-free" curve, and

    2) adding the CDS spread to it.

    So for simplicity, if we had a flat swap curve of 5%, and a flat credit curve of 300bps (3%), if we laid out all the cashflows we expect from a stock for the next 15 or 30 years, we then discount each payment by 8%. And then you can make some assumption of residual value which you can also discount.

    Similar to what you mentioned in Part A, i suspect it will show a CRAZY over-valuation of most shares, ESPECIALLY following recent credit spread widening, and also very high long-term growth assumptions.

    I ran the numbers for the S&P500 using a dividend yield of 1.83%, growth of 3% a year, rates of 5% and a cds spread of 1%, prob not too far from the truth, and 30 years of discounted dividends are worth about 535 points. Or 100 years of dividends are worth 874 points. Obviously S&P trading at 1472, so if these assumptions seem reasonable to you then you might not wanna be long!

    Oh and for every 1bp (0.01%) change in either rates or cds spreads, it looks like it's worth a bit over 2 S&P points by my guestimate.

    hope that helps a bit. also re: treating equity/debt like options on each other, moody's bought a company called KMV a few years ago which did exactly this... is the website. Made sense at the time when I looked at it years ago, although I can't remember the exact details now.

  10. To CDS trader,

    Thank you for the discount rate suggestion. I have to think it through..also thank u for the KMV reference.


  11. Can someone tell me what happens if you hold an in the money put option on a company that goes bankrupt? Do you still need to exercise or will there just be a cash settlement by the exchange?

  12. you are a gifted financial writer

  13. Very interesting posts. Some comments:

    1. CDS are credit puts. They are "side bets" on default likelihood. It is not a zero-sum game since credits can be referenced multiple times. To increase returns in low-yield environment, risk-takers sold more puts at historically low strikes. Volatility increased as default fears have grown, many strikes are now deep in the money and several of these puts are being forced execution in market value pricing risk mechanisms such as synthetic CDOs. This drives up the strikes further and widens spreads. This is where we are today.

    2. CDS v. Equity Valuation. CDS simply represent credit spreads. Intrinsic firm value can be calculated using CAPM: FCFF / WACC-g. So, taking NA.XO for avg levered firms, spreads have widened by 100bps or so since April, 10-yr has tightened by 100bps, net 0. For highly levered firms, NA.HY has widened by 300bps, for low-levered firms NA.IG has widened by 40bps, but it does not matter much since debt is small part of capital structure. So, assuming FCFF and g are constant (big if), one could argue that the 100bp tightening of the 10yr has made low-levered equities more UNDERVALUED now than 6 months ago, avg levered firms the same and high-levered firms are worse off. The leverage factor is less important than potential earnings deterioration (FCFF) and growth slowdown (g), which the market now is trying to determine the magnitude of. Of course, this is all "valuation" and much different from "pricing", which I would be glad to explain further.