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.
Related posts:
Naked CDS, market efficiency and the run on Greece
Rajiv Sethi on EMH
Thursday, March 11, 2010
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By "speculating on the short side of puts" I believe you mean "speculating on the short side of the market by being long puts", since being short (naked) puts has limited potential for gain and essentially unlimited potential for loss (even though the sign of the time decay favors the short put position). And yes, being long/short puts to be short/long the market exerts downward/upward pressure on stock prices through the delta hedging of option market makers.
ReplyDeleteAt the moment I am in fact on the short side of the market via a long put position, and I can verify that at times like this the awareness of these matters becomes all too acute.
Curious, thanks, now I have changed "speculating on the short side of puts" to "speculating on the short side by buying puts".
ReplyDeleteDelta hedging pressure works both ways in stocks, because both puts and calls are allowed by regulators. CDS-bond arb also works both ways, depending on which side of CDS market maker is trading. The point is that there is no breakdown of symmetry alleged by Soros, neither in stocks nor bonds.