Cash & Loans Advice Blog

Protection related to credit events

CDS are used to transfer the credit risk of a reference entity from one party to another. One party (the protection buyer) pays a periodic, fixed premium to another (the protection seller) for protection related to credit events on the reference obligation. If there is no credit event, such as default during the life of the swap, these premiums are the only cash flows . If a credit event occurs the protection seller is obliged to make a payment to the protection buyer. For physically settled contracts, following a credit event, the protection buyer delivers the defaulted reference obligation.

Cash settlement (par minus market value) is the alternative to physical settlement and is used less frequently in standard CDS but overwhelmingly in tranched CDOs. The 2003 ISDA definitions further clarify the three types of credit events:

• Bankruptcy
• Failure to pay
• Restructuring.

Just like cash bonds or loans, CDS transfer credit risk. To remove the interest rate component of a cash bond, a synthetic floating-rate note can be created via an asset swap which eliminates the duration and convexity exposure of the cash bond. An unfunded position in the bond would have to be financed in the repo market. A CDS is equivalent to a financed purchase of a bond with an interest rate hedge (selling protection through a CDS or buying a corporate bond, asset swapping the coupon to floating and financing the holding in the repo market).

How to pick the right credit option

Directional trades: This refers to a situation where the CDS market can be used to take a low-cost bearish view because of a negative basis. If the basis is positive and has widenend for “technical” reasons, it possibly represents an opportunity from a hedging-driven market dislocation. Next post provides an example for Siemens.

Spread trades: Investors who are positive about France Telecom relative to Vodafone can express this outperformance view via selling protection in France Telecom versus buying protection in Vodafone. Depending on the chosen credits this could result in high positive carry trades.

Curve trades/Forward trades: As an issuer’s credit quality deteriorates, the spread curve of the issuer moves from being upward-sloping to inverted. Default curve inversion may present an opportunity to shorten maturity and enhance yield. Curve inversion in the default market also allows investors to purchase forward protection at lower levels. This can be achieved by buying longer dated protection and selling shorter dated protection.

The phase of the credit cycle

According to our correlation matrix high yield is best comparable with equities. The value of $100 invested in January 1987 in high yield and the S&P 500 Index. It can be said that investors realized similar returns over the period Jan. 1987–Dec. 2003. It brings more clarity into the relationship between high yield and equity markets. Obviously both markets are affected by similar macroeconomic factors, so that they show parallel fluctuations in risk. But it is important to note that high yield experienced less risk over this period, meaning that high yield returns experience less volatility than that observed with equities.

It shows historical yields in the high-yield market versus 10-year Treasuries and BBBs. The spread differential varies significantly depending on the phase of the credit cycle.

Making the right online credit decisions

In 1996, General Electric (GE) pioneered the use of an extranet (a closed network for use by people external to the organisation) in its lighting division to develop effective business-to-business relationships. The lighting division established a global network, linking with suppliers worldwide, to enable the company to complete its purchasing transactions more quickly. A feature of the extranet, known as the trade processing network (TPN), allowed GE’s many international suppliers to download GE product specifications and communicate with the company via a secure, encrypted software link over the internet. The benefits of this approach for the lighting division were swift and significant: the cycle time in the purchasing process was reduced, enabling more efficient production and inventory management. GE suppliers continued to become an integrated part of a global community. Furthermore, TPN was employed in seven other GE business divisions as well as being licensed to other manufacturers to use with their suppliers.

In contrast, a survey of websites in 2000 found that 40% of e-mail questions went unanswered. Only 16% of sites followed up with a marketing offer to customers that had purchased from them in the last 30 days, and of these, only 2% were personalised. Other surveys suggest that as many as 60% of people using the internet believe that giving out personal information is “generally unsafe”. Many businesses now recognise the commercial importance of ensuring that their websites are safe and secure, and are seen to be so by their customers.

The Grandosity Issue

Successful real estate speculation leads to grandiosity. Small real estate investors, who missed the stock bear market of 2000-2001, are prone to grandiosity.

Grandiosity, when returns are positive, manifests as extreme good humor and excitement. Grandiosity can be intoxicating. Once experienced, gamblers seek to recreate the high. Day traders continually believe they will have another streak. Tech investors search for the next Microsoft. Real estate developers crave breaking ground on the next mega project.

Yet, even on a winning streak, grandiosity has a down side. A sense of isolation is common. Sudden wealth stands out in a society where savings are accumulated slowly. Grandiosity can lead to a loss of connection with family, friends, colleagues, social norms, and even one’s self.

Grandiosity is often followed by both poor investment results and personal unhappiness. Crashing from grandiosity can be very painful. The detox process leads to grief, sadness, plummeting self-esteem, self-loathing, or depression. Thoughts of suicide are common. Actual suicide is the extreme manifestation of fallen grandiosity.

Although some people are not prone to grandiosity, you should consider any experience you might have with it.

Decreasing fixed expenses

Decreasing your fixed expenses can result in a huge jump in your discretionary income. Oftentimes, though, getting rid of or lowering a fixed expense can take a major lifestyle adjustment. But when you are battling to eliminate debt, the thousands of dollars you may save might well be worth it. Here are some ideas:

1. Ditch the ride. Over my years as a financial planner, I’ve seen few things that suck up as much discretionary income as a car payment. Add in the other costs such as gas, insurance, and maintenance, and you can easily spend $5,000 to
$10,000 per year for the privilege of sitting in traffic. One to two years of riding the bus or subway, or even carpooling with your accountability partner, may get you completely out of debt!

2. Put a smaller roof over your head. There are a lot of reasons why you may have needed a bigger house or apartment in the past. But since the kids moved out, the dog ran away, and you’ve sold a bunch of your stuff at a garage sale, you could make do with less space. A few hundred dollars less per month in rent will go a long way toward getting you out of debt.

3. Cancel your PMI. Mortgage insurance is required by most lenders when they loan you more than 80% of a home’s value. However, when your mortgage balance drops below 80% you are no longer required to pay PMI. Oftentimes, companies will continue to charge it until you ask them to stop. Canceling your PMI as soon as you’re eligible can save hundreds each month.

4. Cancel unused subscriptions/memberships. Whether it’s the gym or the newspaper, there are a lot of things that slowly nickel-and-dime us to death every month. A couple of canceled memberships or subscriptions could easily save $50 per month, or $600 per year!

5. Shop your insurance. If you haven’t updated your life, health, auto, or home insurance in the last few years, now may be a great time. Besides making sure you don’t have too much insurance, you may also find significant savings as you shop.

How to increase income

1. Rent out a room. If you own a house or are renting an apartment by yourself, you might be able to seriously knock down your debt by renting out a room to someone else. An extra $300 to $500 per month goes a long way!

2. Start blogging. You can start an online diary of your own, with ads built right into them, or you can sign on to blog for someone else. Blogging for someone else can pay anywhere from $3 to $20 per post, especially if you have a unique perspective or skill.

3. Freelance. If you have certain job skills or talent, ranging from bookkeeping to website design, you can make significant money working from home. Go to Google and search for “freelance websites” where you can bid on projects people need completed.

4. Tutor. Were you that kid who always got 102% on the math tests? Do you love American History or Spanish verbs? There are a lot of kids who don’t, with parents who are happy to pay $20 per hour for good tutoring. You can tutor on the weekends at your local coffee shop.

5. Turn your hobby into a home business. When we were really poor, my wife learned how to make beaded jewelry at her preschool mom’s group. We started using her creations in place of store-bought gifts, and it wasn’t long before people were asking how to buy them. She works when she wants and makes an extra $2,000 to $3,000 per year.

6. Open a home day care. If you are already a stay-at-home parent, taking care of a few extra kids besides your own can bring in significant money. After a few required classes and a safety inspection, you can start providing day care for other children at $8 to $15 per hour, per child!

7. Recycle. For years, I was that parent scooping up all the cans and bottles after my kid’s baseball games and at my office. The $10 to $20 per week I’d earn on Saturday mornings helped me overcome the weird looks I’d get from my coworkers.