By happenstance, some of the new bonds Greece has issued in its restructuring have a market price close to the total value of the package creditors received — about 22 cents on the euro. Those bonds will help set the CDS payout, and trouble will be averted: CDS holders will receive about 78 cents, roughly equivalent to the loss bondholders suffered. …
If the new Greek bonds had different terms — higher or lower interest payments for instance — their prices could be substantially different, changing the amount the default swaps would pay. Ben Heller, a portfolio manager at New York hedge fund Hutchin Hill Capital, which owns both Greek bonds and CDS, said that means the swaps aren’t doing their job. He said that until the problem is fixed, he “will not use CDS as a hedge against credit exposures anymore.”
In fact Heller told Felix Salmon:
When you think about it, it’s a product that, on certain poorly defined credit events, offers a random payout. So if I want to do that, then I could play roulette at a casino.
So, first of all: yes! I think worry about the definition of credit events is a bit overblown, but the randomness of the payout is a real thing and bizarre and terrifying. It bears re-emphasizing that the method of calculating the Greek CDS payout bears no relation whatsoever to the default risk that it was supposedly hedging.
But, also: no! Read more »