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Enron Mail |
Vasant,
Can you, please, review this Newsletter article. I had to put something together rather quickly last night. Vince ---------------------- Forwarded by Vince J Kaminski/HOU/ECT on 04/02/2001= =20 07:37 AM --------------------------- VKaminski@aol.com on 04/01/2001 11:22:50 PM To: vkamins@enron.com cc: VKaminski@aol.com=20 Subject: Newsletter Complexity of modern financial markets never ceases toamaze me. Te links = =20 between different financial instruments are sometimes verysubtle and it=20 takes =20 understanding of many different types of transactions toexplain the =20 interdependencies. Recently, I have been receiving E-mails fromdifferent = =20 academics and practitioners asking for explanation of anomalydetected in = =20 pricing of credit default swaps. One E-mail asked the followingquestion: = =20 According to a Bank of America publication, your (Enron) default swapspread= s =20 are consistently trading about 80 basis points wider than your assetswaps. = =20 Any idea of what is going on here?=20 Icame up with an answer with the help of Bryan Seyfried from Enron =20 Credit.com,our unit in London trading credit protection tools. The answer = =20 requiresexplaining first what are credit default swaps. In a plain-vanilla = =20 credit default swapstructure, the buyer pays a premium for protection he or= =20 she receives in case acredit event (default) takes place in the case of a = =20 reference entity. In theevent of default by the reference entity, the selle= r =20 of the protection isrequired to pay an amount equal to the difference=20 between =20 the initial price ofthe credit exposure and its recovery value. For example= , =20 the protection may bepurchased for a bond issued by the reference entity. I= n =20 the case of a default,the seller of protection pays the difference between = =20 the face value of the bondand its current(post-default) market price. =20 Mispricing of credit default swaps often takes placefollowing an issuance b= y =20 the reference entity of convertible bonds. Aconvertible bond can be looked= =20 at =20 as a combination of a regular coupon bond anda long-term equity option. =20 Sometimes the equity option may be mispriced and beavailable at a lower=20 price =20 than the comparable equity options that can beobtained at the derivatives = =20 markets. The hedge funds buy convertible bonds toacquire the option=20 component =20 but are not interested in taking the issuer=01,scredit. They seek to lay of= f =20 credit risk by selling the asset swaps or bybuying protection through=20 default =20 swaps. This arbitrage leads in many cases,after a large convertible bonds = =20 issue, to imbalance in the asset swaps marketsvs. default swaps markets. Th= e =20 cost of credit protection goes up but this hasnothing to do with =20 deterioration of the issuer=01,s credit. =20 One may expect that this imbalance will be eliminated overtime and the=20 prices =20 of default and asset swaps will converge. Frictions andrigidities in the = =20 capital markets may slow down this process.=20 Enron issues recently a$1.9 billion convertible bond that became a target o= f =20 arbitrage activitiescarried out by the hedge funds. What is very interestin= g =20 is that analysts wholook at one segment of the financial markets in=20 isolation =20 from other segmentsmay be unable to explain the dynamics of prices. =20 Globalization has arrived andit has more than one dimension. - credit.doc
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