“[N]o institution was in a position to sell credit default swaps as a natural hedge against its other business.”
Why would both ends of a CDS need to hedge some risk in order for the CDS to be economically beneficial? I fail to see how hedging is the sine qua non of economic utility. If that were the case, who is a natural buyer of bonds? I’m sure Kling is incapable of answering that question because as a matter of pure logic, any answer to that question is an answer to his, since selling protection through a CDS is economically equivalent to buying the underlying bond (ignoring CDS collateral, which complicates the matter).
In any case, it seems futures and forwards are acceptable means of speculation, but CDS are not. In the case of fuel and other energy and commodity derivatives, there are those in the market who have bona fide economic exposure to the underlying risk. For example, an airline might enter into a swap or a forward contract to lock in a price for fuel, so that it can plan around that price and won’t be brutalized by volatility in fuel prices. The other end of the trade could very well be an entity with no bona fide economic exposure to fuel prices. Rather, that entity wishes to speculate on the movement of energy prices. Both benefit through contract in that both get what they want: the airline wants stable fuel prices and the speculator wants the opportunity to profit by expressing a view on the movement of fuel prices.
The same applies to CDS. Certain entities in the market have bona fide economic exposure to credit risk. For example, banks. In order to shed this risk, banks will contract with another party, the protection seller, to absorb this credit risk. The bank wants to unload its credit risk and the other party wants to speculate as to the probability of default on and, more generally, the movement of credit spreads relative to the underlying credit. And so, both parties get what they want and the transaction is, at a minimum, economically useful ex ante.
Also published on the Atlantic Monthly’s Business Channel.
Originally published at Derivative Dribble and reproduced here with the author’s permission.