Forex Investment and Currency Trading

Two year swap spreads briefly breached 100 bps last Friday as concerns over accurate LIBOR fixing levels rolled through the market. Illustrating the decoupling to credit markets, IG spreads tightened by 7 bps and banks were tighter by 12 on the heels of strong equity markets. The trouble with LIBOR lies with
its essence: one borrowing rate to reflect the overall rates to all panel bank members. That works when both overall bank risk is low and the dispersion of risks across banks is small. Both are clearly not the case currently. The variability in individual 3 month offered rates stood at 3 bps last Friday vs. an 80 bps
differential in 1 yr CDS spreads. Considering today’s volatility in the context of continued elevated levels of LIBOR vs. Fed Funds, the message remains that bank balance sheet capacity remains constrained and that the acceleration in Central Bank liquidity injections has not resolved that fundamental issue.

Credit Derivatives Market Grows to $62 Trillion

ISDA released its 2007 year-end market survey on April 16, which estimates that CDS notional grew by 81% in 2007, to $62 trillion.1 See Figure 7. Moreover, despite recent market conditions, ISDA estimates suggest that CDS notional grew by 37% during the second half of 2007, compared with 32% during the second half of 2006.

Risk Is Lower than Headline Notional

Under many circumstances, the size of the CDS market may grow without any change in overall risk exposure. For example, if an investor buys protection in an index and sells protection in each of the underlying constituents, reported CDS notional will grow, even though net credit exposure will be unchanged.

Mark-to-Market Value

ISDA also estimates that, as of June 2007, gross mark-to-market value was approximately 2.2% of notional, or net 0.5% of notional. Mark-to-market estimates are taken together across the combined $454 trillion credit, interest rate, and equity derivatives markets. These figures suggest a dollar gross exposure of $9.8 trillion, and net exposure (before collateral is taken into account) of $2.3 trillion, again as of June 2007.
While there is no specific breakout to credit derivatives, presumably mark-to-market values have become far more severe since the onset of the credit crisis. Since the estimates’ as-of date (June 2007), investment grade credit has lost about 3.1% in total return, and high yield 5.5%. Strictly speaking, that would mean another $2.4 trillion in mark-to-market losses. However, because not all trades implemented in June 2007 are still in place, the effect on overall CDS mark-to-market exposure is unclear.