Thursday, November 02, 2006

Only 3CPO could keep track of this stuff

Guambat is only just starting to get his befuddled fat head around the CDS thingo, and has yet to respond to a querie from a reader asking how LBOs and CDSs relate. Guambat will never understand LBW.

Now there's this from the Financial Times' blog FT Alphaville:
Daily report: credit default swaps
The cost of buying credit protection in the derivatives market continued to trade at very low levels in London markets on Wednesday morning, with the Itraxx investment grade index and the crossover indices respectively opening at 23 ¾ and 245 basis points respectively.

These two indices measure the cost of buying insurance against default on a basket of bonds issued by investment grade and sub-investment grade companies.

The recent, remarkable decline in the cost of credit protection in the derivatives market is prompting fierce debate in London this week about the behind-the-scenes impact on the markets now being exerted by an innovative new structured credit product.

In particular, there is rising speculation that prices are currently being distorted by so-called constant proportion debt obligation (CPDO) instruments – a new type of product which was only introduced into London markets two months ago.

Tracking the impact of products such as CPDO’s on market trends is extremely hard, since the credit market is very opaque and banks are reluctant to discuss innovations such as CPDOs. However, the recent decline in the cost of credit insurance has baffled many investors, particularly since the trend has left derivatives decoupled from cash bonds.

The CPDO instrument was first introduced by ABN Amro in August this year with a product called Surf. Since then several other banks have launched similar products, although they have tended to have different names.

These instruments all carry echoes of the traditional credit CPPI model, but are structured specifically to ensure a certain return for investors. This allows rating agencies to assign a rating to the note coupon – which in turn makes it easier for dealers to market the product to investors, specifically banks.

All CPDO instruments reference a mixture of the CDX and iTraxx indices – or the main two credit derivatives indexes in the US and Europe respectively. This means that when banks issue these notes, or when the funds rebalance their swaps at the index roll every six months, there is a wave of selling credit protection – and this appears to be having a knock-on impact on CDS spreads.

And that has left some observers pointing the finger at the CPDO innovation. “[There has been] chopping month end tranche trading,” Lehman brothers warned in a note to its clients today, pointing out that the big unknown was the degree that “CPDO is helping the market to go tighter.” Or as Marcus Schuler, head of integrated credit marketing at Deutsche Bank added: “The recent weekly performance clearly shows the CPDO squeeze.”

So Guambat called on 3CPO to translate this into language Guambat understands. 3CPO said to go ask R2D2. R2D2 very comphensively and enthusiastically explained everything. But Guambat does not speak R2D2.

So, Guambat has dragged back to his burrow to figure out how to make some "free money" with "negative basis trades" of CDSs.

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