Rajiv Sethi continues the theme of credit default swaps and their role in self-validating bear raids, and he has included an excerpt from an article of George Soros. I am very concerned about the excess volatility in credit markets, but I think that this specific attack by Soros on CDS is pretty weak:
"First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks. The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks. The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds."
His comparison of stock market and bond market is misleading, as losing on long position decreases risk both in stocks and in long-credit side of CDS. And I doubt anybody would agree with the stockmarket version of the point George Soros makes about limited risk and unlimited reward. Have you heard anybody saying that asymmetric nature of put options encourages speculating on the short side by buying puts, which in turn exerts a downward pressure on the underlying stocks? There were not enough buyers of deep out of the money Pets.com puts in 1999, and I wish that CDS spreads on Iceland were wider in 2005.
Naked CDS, market efficiency and the run on Greece
Rajiv Sethi on EMH
"If money isn't loosened up, this sucker could go down" - George W. Bush warned in September 2008