Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Credit derivatives versus cash markets

In a recent paper (Packer, F.and Wooldridge, P. D. (2005), “Overview: repricing in
credit markets”, BIS Quarterly Review, June 2005), the BIS compares the
resilience of the credit derivative markets and the cash markets during the
turbulence of May 2005 after the GM and Ford downgrades. They write:

“ the downgrade of the auto makers had the potential to cause dislocation in credit
markets. In the event, cash markets appeared to adjust in an orderly way to the downgrade.
Credit derivatives markets were more adversely affected, with CDS spreads ‘gapping’ higher on several days in the first half of May and lower in the
second half … Yet spillovers from credit derivatives markets to other markets were

They also contrast the lack of contagion to other markets in May 2005 with the massive
contagion from the Russian default and the collapse of LTCM in 1998.

While the statements are factually correct, the implicit suggestions that the
credit derivative market is less resilient and less important is misleading.
As the paper itself points out, the major trigger for the turmoil of May 2005
was a sharp fall in default correlations. Since contagion is by definition a sharp rise
in correlations, it is not surprising that a fall in default correlations is not
accompanied by contagion. Similarly, it is correlated defaults that cause the
greatest stress on the cash bond markets. Uncorrelated defaults are quite benign
in their impact. It is only in the credit derivative markets – n‘th to default
credit swaps and the lower tranches of a CDO – that a fall in default correlations
can cause havoc. It is precisely in these markets that players lost a lot of money.

The relative resilience of the cash market and the credit derivative market
can be truly tested when there is
a credit event which is more symmetric in their impact on the two markets.


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