One result of the recent credit crisis is an increased focus on CDS spreads as an early indicator of default risk. This focus has led to increased transparency in the CDS market and more readily available information regarding what those markets are saying about a particular issuer’s probability of default.
When CDS spreads widen, it’s a sign from the derivatives market that a company’s probability of default has increased, and equity and fixed income markets should be expected to respond in kind. The question is: how do we efficiently capture and capitalize on that information?
An issuer’s CDS spreads, and the recent movements of those spreads, provide quick, valuable information on whether to open or close a position. However, monitoring CDS spreads on an issuer-by-issuer basis can be time consuming and, frankly, inadequate from a risk oversight perspective.
If you’re digging into a company based on major news stories or some recent event, there’s a good chance you’re going to be late to the game, and the information provided by CDS spreads will already be reflected in the equity and fixed income markets. Rather than taking the reactive approach of “What are the CDS markets saying about company X after event Y, and to what degree are we exposed to company X?”, we can try to fully capture the value of movements in CDS spreads as an early indicator with a more proactive question: “What is our exposure to issuers with widening CDS spreads?”
In other words: Assuming I don’t have a clear picture of the credit profile of every company held by my firm, where are the CDS markets indicating significant changes in the probability of default? There are a number of factors to determining what’s a significant movement:
- Percentage or basis point change in spread
- Absolute change or change relative to a benchmark, sector, country, etc.
- Time period for change: one day, one week, one month
- Tenor of spreads: Anywhere from 1-10 year spreads
Once we’ve determined the companies with indications of a significant credit event, we want to know everywhere that we’re exposed to that issuer. A default, or simply an increased probability of default, can affect all asset classes. It’s essential to identify our exposure to every equity share class, ADR, and preferred as well as every bond, option, derivative, or other instrument linked to or issued by that company.
To ensure that we’re able to capture the value of CDS spread movements as an early indicator the analysis should be run as frequently as the data allows (daily if possible). While the amount of data going into such an analysis can be immense, the communication of the results must be concise so that it can be quickly distributed, consumed, and acted upon. For example, it may be best to simply send a list of the 5-10 issuers with indications of increased default risk and market value held to traders and portfolio managers prior to the market open.
If the CDS market is telling you that an issuer has an increased risk of default, there are a number of questions for which you’ll want a quick answer:
- What is our firm’s aggregate market value at risk from all securities linked to that issuer?
- How many portfolios and individual positions do we hold in that issuer’s securities?
- How liquid are those securities and how long would it take to unwind those positions?
With increased transparency into the CDS market, some valuable data points have been added to the risk overseer’s arsenal. Likewise new applications, like FactSet’s Security Exposures Analysis, have been developed specifically for combing through that data and quickly answering the questions posed above. While CDS spreads are considered an early indicator of increased default risk, it doesn’t take long for the non-CDS markets to catch up. Setting up a timely, flexible process which concisely summarizes the relevant data is essential if you wish to stay proactively ahead of the credit events indicated by the CDS market.