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Darrell Duffie: Managing Risk of Credit Default Swaps

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Darrell Duffie: Managing Risk of Credit Default Swaps

A Stanford research team proposes changes to control investor exposure to sovereign default risk.
Greek Deputy Finance Minister Christos Staikouras smiles at reporters during a briefing at a ministry hall in Athens, 2013. (Reuters photo by Yorgos Karahalis )

If you're a bondholder of sovereign debt and think you've covered your risks by purchasing credit default swaps, think again.

According to Darrell Duffie, finance professor at Stanford GSB, and Stanford economics student Mohit Thukral, a flaw within credit default swap (CDS) contracts means that only a small fraction of bondholder losses may be covered in the event of a sovereign debt restructuring.

The flaw is tied to the fact that current CDS contracts only pay buyers of protection based on the price of the sovereign's outstanding bonds, even if the sovereign has just exchanged its legacy bonds for a much smaller amount of new bonds. This CDS payout ignores the additional loss to a bondholder from the effect of this "haircut."

In a recently released research paper, Duffie and Thukral propose tying CDS settlements to the face value of new bonds that is given to bondholders per unit face value of old bonds. The resulting CDS payment approximates actual bondholder losses, allowing for better sovereign default risk management and CDS pricing that more accurately reveals sovereign default risk.

"The current design of credit derivatives is of questionable value for managing the risk of sovereign default, which is a significant issue given the current stresses on the Eurozone," says Duffie. "Unless there is a change in the contract design, such as the one we propose, investors could be left without an effective tool for controlling their exposure to sovereign default, and CDS prices would be unreliable gauges of true default risk."

Furthermore, he explains, if the CDS market is not an effective tool for managing risk, investors may have even more reason to shy away from sovereign bond purchases, leading to unintended consequences for market stability.

Duffie and Thukral, an undergraduate economics major who recently took Duffie's MBA "Debt Markets" class, began their research following the restructuring of Greek sovereign debt in March of this year, when they realized the shortcomings of current CDS contracts. They propose a straightforward redesign of CDS contracts that would allow settlement based on the market value of whatever the sovereign government gives the bondholder in exchange for each old bond; this market value would be determined in a settlement auction.

In practice, a sovereign government may give a package of several financial instruments in exchange for each old bond. Bondholders of Greek debt, for example, received a combination of new bonds, GDP-linked securities, and PSI payment notes that are obligations of the European Financial Stability Facility.

According to Duffie and Thukral's proposal, the redesigned CDS contract would allow settlement based on the market value of the entire exchange package. This would mitigate one of the problems that arose with the Greek debt restructuring; namely, that the protection payment ignored the remainder of the exchange package.

In this way, the team's proposal also provides a mechanism whereby the bond market can digest the complex instruments that may be created in a sovereign debt restructuring. This is important because not all bondholders are well situated to deal with the package of instruments they may receive in a restructuring.

"At the end of the day, the goal is to ensure that the CDS market remains an effective means for bond investors to manage risk," concludes Duffie. "And that simply means protection payments must be reliably correlated with actual bondholder losses."

The complete proposal, "Redesigning Credit Derivatives to Better Cover Sovereign Default Risk," is a research paper of the Stanford University Rock Center for Corporate Governance, a joint endeavor of the law and business schools.

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