How then can large sales of credit default swaps be manifestations of creditworthiness? Moreover, why would any investor want to purchase a credit default swap if the intention is to not profit of future default of the reference loan? Is the motivation then an effect stemming from expectations of asset price inflation? e.g. bond prices going up?
The bank structuring the deal brings the reference. It is usually a credit with a rather remote probability of defaulting and the premium is accordingly computed. That allows the insurance provider to sell credible insurance for the portfolio and becuase it is a high grade credit, it is an insurable risk for which the insurer accepts the business for nominal premium, provision of insurance hedging the borrowers in that industry and for that specific borrower.
Also because of the informed nature of trading CDS spreads provide an instant window to credit costs and to the overall macroeconomic environment down to even profitability of a sector/corporate.
It is out of question that the CDS derivatives are connected with credit risk measure and perception and, therefore , they can be utilized as evaluation and/or risk protection tools. However , for their inherent speculative nature, and the dimensional structure of the OTC derivatives market, it is not always easy, in my opinion, to clear out the scene from the speculative part of this type of transaction. I would not compare precisely the risk evaluations made in the insurance Market with the ones made in the OTC one! If you track a trend and you sell and buy basing your decisions on the technical analysis suggested by your trading system, you do not consider the creditworthiness directly but more precisely also some speculative effects of it. To clear the evaluation of creditworthiness from distortive betting effects it is not always possible, in my opinion, as the speculative betting content of the CDS transactions, might sometimes alter improperly the picture.
Kind regards
Alberto
The context of likelihood of profit from a credit default swap is conceivably very unpredictable due to immense risk associated to such a decision to purchase. Hence, a decision to purchase such requires a very workable strategy to convert risks into profit or return. The only control mechanism is the contract period. I hope I got it.
HI,
You may a look to this recent paper:
. Anchoring Credit Default Swap Spreads to Firm Fundamentals.
By: Bai, Jennie; Wu, Liuren. Journal of Financial & Quantitative Analysis. Oct2016, Vol. 51 Issue 5, p1521-1543. 23p.
Best regards
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