Is the CDS market a fair game???

The credit default swap market survived the credit crunch of 2007 well but still they are considered as an important tool to managing credit risk. A financial institution can reduce its credit exposure to particular companies by buying protection. It can also use CDSs to diversify its credit risk. But now the question arises that how much fair this CDS game is???

In a very simple way this is a contract that provides insurance against the risk of default by particular company. There is one important difference between CDSs and other OTC derivatives that other OTC derivatives are depends on interest rate, exchange rates, equity indices, commodity prices and so on while on other hand CDS spread depends on the probability that the particular company will default on during a particular period of time. In case of other OTC derivatives there is no reason that one market participant will have more information that any other market participant while in case of CDS some market participants have more information to estimate this probability than others. Any financial institution which is involve in market advisory, consultancy, providing loans and funds, handling new issues of company is likely to have more information about credit worthiness of that particular company than other financial institutions those have nothing to do with that particular company. This whole phenomenon is known as asymmetric information problem.

Whether asymmetric information will curtail the expansion of credit default swap market is to be seen. Some financial institutions emphasizes that the decision of buying protection against the risk of default by the company is generally taken by risk management team of that particular team and it has nothing to do with any special distribution that may exist elsewhere in the financial institution about the company. Some market participants says that the growth of CDS market will continue and that it will be as big as the interest rate swap market by 2010.

High Fiscal Deficit : A big DEBT trap for economy

The markets were expecting something big in FM's budget speech but all those expectations turned into disappointments as there was nothing according to expectations. Both bond and equity market went into distracted state as FM announced that the fiscal deficit would be 6.8% of GDP. And then as a result the benchmark index closed as 6% down on that day while on other hand 10-yr govt. paper yield was shot up by approx 1.3% which means that bond price and bond yield moves in opposite direction.

Lets try to understand that why there was such type of response in both the markets due to this economical number.

In a very simple way the fiscal deficit can be understand as the amount by which the govt. expenditure exceeds its receipts including borrowings. So now its clear that if this fiscal deficit moves up then govt. will have to borrow more funds in order to its expenditure. In the current financial year our fiscal deficit figure is about to 4 lakh cr. which is approx four times more than the budget estimates in last yr.

If govt. will borrow approx 4 lakh cr from market then its clearly means that there will be less fund available with banks for public sector. Our privet investment will suffer ans so will our growth. If the system is left with fewer rupees to lend, there will be a demand-supply mismatch and interest rates will move up.

This is the reason that interest rate sensitive stocks lost their value in the market on the budget day. When interest rates move up, bond prices fall as investors chase bonds offering higher rates. As its widely known that banks hold a substantial part of their portfolio in bonds. Thus, falling bond prices affect their profitability. BSE Bankex sold the most on the day the Budget was announced.

The story doesn't stops here only. Higher fiscal deficit over a period of time brings instability into the financial system. As a result, there is a fair chance of India getting downgraded by international credit rating agencies. This will make India more risky for foreign investors and lenders. Consequently, lenders would charge a higher rate of interest on borrowings from Indian companies.

The other most important impact of higher fiscal deficit is this that it will affect the exchange rate. So as a result our import will move on and increase in import will increase demand of foreign currency. This increased demand of foreign currency will affect the value of Indian Rupee and as a result our currency (INR) will depreciate.