The Credit Default Swap of Central East European Countries - Essay Example

The Credit Default Swap of Central East European Countries Introduction The research dissertation is on the topic of examining the difference in risk premium spread in the funding rate, reflected in the Credit Default Swap (CDS) of Central East European (CEE) countries which have currency board restriction such as nations like Bulgaria. The dissertation is based on the financial analysis and econometrics. Quantitative methods have been used in the dissertation process to examine the risk premium spread. Risk premium is evaluated on the basis of fund that the CEE country is utilizing in procuring from abroad. Only those countries which have currency board restrictions, like Bulgaria, are taken for this dissertation research. Risk in entailment of equity investment is high in Central European countries compared to Countries of Western Europe and this is mainly due to factors such as weak rule of the governments, difficult and complicated financial accounts of organizations, currency risks, transparent rule in government institutions etc. Economic performance of each country is unique and therefore equity risk premium is different for each country.The currency board is the controller of interest rates and provides financial stability to the country. The CDS premium is a powerful instrument in the credit derivatives market because it is a direct tool for measuring the credit default spreads. CDS spreads is in proportion to the pure valuation of defaulting risk of the primary body. Credit risk is tested by approximating the equity price and the volatility jumps in the financial market. CDS spread commonly referred is the premium payment for a CDS. Credit Default Swap spreads is a yardstick for pricing and hedging in securities. “Risk premiums for Central Europe have increased substantially over the past two years and may well come down again when confidence returns to global financial markets. This may represent an excellent buying opportunity, as risk premiums tend to rise or even overshoot during turbulent financial markets.” (Nemethy 2009). Objectives of the dissertation The main objective of this dissertation is to examine the differences in the risk premium reflected in the CDS of CEE countries, especially Bulgaria. Bulgaria has a currency board restriction. Countries which have currency board restrictions face less degree of inflation and experience more GDP growth. The idea of this dissertation is to convince that risk premiums in CDS have an impact on the economy and has differences in the risk premium. Credit default swaps are an indicator of global financial crisis. Credit default swaps has the ability to forecast both stock as well as currency market crises. The purchaser in the CDS pays the risk premium like a mutual fund insurance policy on the speculation that the share worth will not decline but will only increase. The CDS seller has the obligation to pay the purchaser if the stock is defaulting. Therefore CDS value is equalized as risk premium in addition to funds of equivalent maturity of the company. CDS premiums are a sign of future potential of investors and results in the projection of currency and stock markets. The premium is a clear indicator of the shareholder’s awareness of risk in the CDS spread. CEE countries especially Bulgaria has high risk premium therefore it is implementing various solution through its currency control board to control the system. The main objective is to reduce the difference in the risk premium so that the country does not face financial instability in the wake of recession. The central eastern European countries are taking actions to control the fiscal deficits. “Bulgaria has been warned by Fitch that it may see its credit rating lowered to junk grade as its external debt will exceed the total output, which may threaten the financial stability.” (Central, East European countries seen less vulnerable from default risk, 2010). Credit default swaps play a major role in determining the policies of financial markets and financial instruments because with swaps there is risk premium associated which has huge impact on the financial stability of an economy. Speculative trading should be banned in Credit default spreads. The CEE countries are very concerned about the credit default spreads and the associated risk premiums because if the firm defaults then the CDS seller will have to pay the buyer for the negative losses suffered and the purchaser stops the payment of premiums. Therefore the main objective is to reduce the risk premium in the CDS of CEE countries especially Bulgaria which has a currency board restriction. Literature review In the book on “an introduction to credit derivatives” by Moorad Choudhry pg- 76 has stated that the credit default curves of a country is reflected through the credit curves and the shape of this curve is inclined to the requirement and deliverance of credit protection in the CDS markets. The risk associated depends upon the credit quality in the CDS. Changes in the premium for Credit Default Swaps are shown in the spreads in the market. “The empirical literature on swap spreads has found that they also contain a liquidity premium. However the liquidity premium component of swap spreads appears to be much more persistent than the default premium component (Liu, Longstaff, and Mandell (2006)), so most of the variation in swap spreads is expected to be caused by variations in default risk.” (Gonzalez-Hermisillo 2008, p.13). “Two different measures of aggregate credit or default risk are examined. The most direct one, because it prices in the cost of buying insurance against default, is credit default swaps.” (Gonzalez-Hermisillo 2008, p.12). In the book “the credit default swap basis” by Moorad Choudhry, pg – 70 he emphasizes that there is a protecting buyer and a protecting seller in a CDS contract. The protection purchaser bears the counterparty stake of the defensive seller on the incidence of a credit happening. It is particularly important if the protection vendor is unable to fulfil his obligation. This particular feature of the CDS contract will force the basis downwards and to counterbalance this risk the buyer will look to a CDS premium which is lower than the cash asset swap spread. Similarly the protection vendor bears the counterparty stake of the protection purchaser. The Repo market rate is a liquid name in the Credit Default Swap market. As mentioned in the world economic outlook magazine April 2009 for crisis and recovery, the CEE economies are facing great increase and the countries risk a premium which is having harsh effects on their economy. Fluctuations in exchange rates are a driving force in the risk premiums. Since Bulgaria has a currency board restriction it has fixed exchange rate. “Bulgaria’s credit default swaps (CDS) slipped one point from March 6’s record of 699 basis points. London-based traders noted liquidity is currently much lower than in the summer, when CDS traded much cheaper. Despite the low liquidity, all analysts polled said CDS rates are a reliable indicator of what investors think of the economy.” (Dnevnik 2009). Bulgaria’s bond ratings and default spreads shows the country’s risk premium. “This table summarizes the latest bond ratings and appropriate default spreads for Bulgaria.” (Damodaran 2010). Country Region Long-Term Rating Adj. Default Spread Total Risk Premium Country Risk Bulgaria Eastern Europe Baa3 200 7.50% 3.00% (Country default spreads and risk premiums, 2010). According to Management Accounting Information Strategy beyond 2000 pilot paper by CIMA, pg-1067 it is mentioned that a combination of new market credit derivatives with traditional derivatives can reduce the risk exposure. More credit default swaps indicate more financial crisis and so there is high premium risk. Therefore Bulgaria should check its risk premium in CDS spreads. Research Methods: The Research methods that would be used would be a combination of financial analysis, econometrics and other methods that would help reaffirm the research hypothesis and fulfill the aims and objectives of this research paper. It also needs to consider the fact that since it is linked to evaluating the risk premium over the benchmarks that the CEE country is paying out in order to obtain funds from abroad. In this study, the eligible CEE countries for the study are those with currency board restrictions. Thus the main criteria in this research study are as follows: Evaluation of risk premiums Its spread for funding rates The aspect of credit default swaps (CDS) Context of Central European economies (CEE) By far the most important aspect that has to be taken care of in a research study of this kind is that the quantitative analysis has to be robust and genuine. “In summary, a credit default swap is a contract where one party to the contract pays a small periodic premium to the other, in return for protection against a credit event (financial difficulty) of a known reference entity (company).” (A beginners guide to credit default swaps, 2007). Arrow et al (2005) specifies the conditionality’s for the absence of default risk premium in the gamut of risk-adverse investors. “First, defaults on different bonds must be autonomous. Second, investors must be able to diversify away any idiosyncratic risks by holding a sufficiently large portfolio of bonds…. Can we tell from the data whether there is a sovereign risk premium and, if so, how significant it is?” (Remolona, Scatigna & Wu 2007, p.28). Apparently, it is now possible to draw up a chart depicting the total risk premiums and Its corresponding country risks: serial Country Total risks price Country risk 1. Albania 11.25 6.75% 2. Armenia 9.00 4.50% 3. Azerbaijan 8.25 3.75% 4. Bosnia & Herzegovina 12.75 8.25% 5. Bulgaria 7.50 3.00% 6. Croatia 7.50 3.00% 7. Hungary 6.90 2.40% 8. Kazakisthan 7.20 2.70% 9. Lithuania 6.90 2.40% 10. Poland 6.08 1.58% 11. Russia 6.90 2.40% 12. Ukraine 12 .75 8.25% The facts about premium rates are that these are higher when the element of risk bearing is more, especially in the context of riskier countries rather than safe ones. From the above, it is deduced that countries like Albania, Bosnia & Herzegovina and Ukraine having high total risk price(11.25, 12.75) also have substantial country risk(6.75%, 8.25%). (Damodaran 2010). In a study of this genre which seeks to explain and evaluate credit risks in the backdrop of deepening economic recession and country specific issues, perhaps this research method also needs to consider the reports provided by major credit rating agencies like Moody, S&P, Fitch, etc. to form an estimate of how and why fluctuations take place and what are the parameters that determine it. However, one of the major drawbacks of this kind of assessment would be that assessments differ from one rating agency to another. Besides, these risks may be of a volatile nature that may not be subject to precise and accurate mathematical calculation and could differ with regard to the mathematical inputs that have been made. Thus it has been determined that for the purpose of this study, the long term relationship between Hungarian sovereign FC bonds and the Hungarian sovereign CDS market and the basic market of the price discovery of credit risk Thus, it is evident that proper mathematical tools need to be employed for assessing the differences in spreads among CEE countries. The best method that could be used for a research method of this kind would be co-integration method. This may be deduced from the fact that “Credit spreads of risky countries respond to the changes in global sentiment in a more sensitive manner. Firstly, as result of the same magnitude of deterioration in the global economic activity, the probability of bankruptcy of countries those are already excessively indebted increases to a greater degree. Secondly, if the global component grows (declines) because international investors’ financing position deteriorates (improves), they reduce (increase) their position.” (Kornel kisgergely: what moved sovereign cds spreads in the period of financial turbulence? 2009, p.3). From the above, it is evident that the impact of favourable or adverse position of foreign countries does play a significant role in determining the level and quantum of risk of CDS in CEE countries. However, much would depend upon the surroundings of the specific country and how risk factors impinge upon it. As a general rule, it is now reported by Moody, that the economic scenario of countries like Bulgaria and Hungary are improving Ethics: It is evident that proper secrecy and ethical considerations need to be made before, during, and after gaining access to private, confidential and classified information under various interventions for the purpose of research. For one thing that identifies the respondents need to be changed in order to protect them from any kind of harm and embarrassment in later time. For another, the receipt of such information that is gained from a research study of this kind need also be of a private nature in order to avoid market risks and detriments. “The third criteria in the survey related to how companies are monitored and in particular how ethical, social and environmental issues of concern are reported back to trustees.” (Top 100 UK pension funds – how ethical are they, n.d., p.7). Expected outcomes of the study: It is observed that in the case of companies with floating rate, the availability of strong correlation is observed between changes in CDS spreads and the shifts in the exchange rate. However, it is difficult to determine the direction of causality here. Obviously, the CDS and the exchange rate premiums segment are determined by identical elements. Thus an increased CDS would in turn also mean a higher risk premium, but a weakened exchange rate could also spell corporate liquidation because it entails an innate debt burden and responsibility. The aspect of CDS in CEE countries need to be seen in the context of the present worldwide economic recession and low business prospects. This had begun during 2007 and is expected to last a few more years, before the boom period begins. According to reliable sources, forecasts of the economic status of Central East European (CEE) countries who have currency board restrictions are no better off than their European counterparts. This is because the states of CEE are more susceptible to market vicissitudes and pressures than their western equals. Their economies are evolving and depend heavily on foreign capital which may be slow and sure. “Having raised money abroad to fund their post-communist transformations, almost all CEE countries face challenges in refinancing their external obligations.” (Wagstyl 2009, p.27). Further, it could be stated that investments in Central Europe may not be an acceptable proposition as would be in other destinations in Europe, or Eastern countries. With credit default swaps in governments on the higher side, the fiscal deficits in the private sector are also cause for concern. Perhaps the fact that equity investments in these regions are low, and combined with inept governance, corruption, infra-structural problems, the economic situation in Central Europe needs a facelift to become viable once again. In all fairness, the equity premium situation in this region needs to be viewed separately for each type of potential opportunity if it were to become viable and progressive once again. (Nemethy 2009). From the above depicted chart it is evident that Hungary, with its innate reverses, (its enduring and very sizable twin budget and current account deficits), will present a higher risk compared with Slovenia which has lower deficits and has mitigated its currency risk by adopting the Euro. Thus, in the context of the Central Europe what emerges is that things have to be considered on a case-to-case basis and not on a total position of what has transpired in these parts of Europe. For one thing, the conditions present in Western Europe which presents more affluence and growth rates cannot be compared with Eastern Europe which is plagued with a plethora of ills, serious or otherwise. Thus only the comparable areas between the Europe should be undertaken lest the analysis and interpretations be premised on wrong estimates and presumptions. With risk premiums moving upwards in the graph for Central Europe over the last few years, it is believed that only a recharge of confidence back among investors could save the situation, more so in the present circumstances where business prospects are just gaining momentum. CEE countries need to put their act together if they could consider themselves competitive and a decisive force in this part of Europe. Their performance should say it all and they need to keep their sights focused firmly on the future, with more challenges and opportunists then there was ever before. The aspects that need to be kept in mind, is that of country risk premium, which seeks to be a imperative ingredient in such cases and need to be well thought-out in design and implementation process of the financial management system. It indeed has a major role and responsibility in security transactions having to do with increased returns and lowered risks on equity. Moreover, the movements of country risk premium need to be gauged over time and for that variations or deviations are reported and action taken promptly to remedy the situation before it goes out of control. Conclusions: There are reasons to believe that in the context of a research paper of this kind, the impact of CDS is indeed central or a core issue that needs to be tackled well in advance before a final decision is taken. Perhaps if the research related to areas other than CSS, Western Europe or United Kingdom, for instance, the deliberations, analyses and occlusions would have been entirely different from what has happened in this case. Again, there are strong pointers that the global crisis has played an influential and crucial part in the determination of evaluating risk premium spread for funding rates in the CDS of CEE. Therefore, it may be safely believed that the recession of this crisis could augur in better days for the economy as a whole and individual players specifically. The research method that needs to be followed is underpinned by well thought-out props for empirical research and use of mathematical tools and techniques that could provide the right inputs and directions for a research study of this genre. This research could also be a premise for more advanced and detailed study on this subject in later years. Besides, In future, a greater degree of involvement and commitment on the part of the research team is necessary not only in terms of gleaning accurate and informative survey inputs but also assimilating it in accordance with accepted and desired procedures. Reference List A beginners guide to credit default swaps, 2007. [Online] Rich newman. Available at: http://richnewman.wordpress.com/2007/12/09/a-beginners-guide-to-credit-default-swaps/ [Accessed 2 April 2010]. Central,East European countries seen less vulnerable from default risk, 2010. [Online] English peopls daily online. Available at: http://english.peopledaily.com.cn/90001/90778/90858/90865/6917338.html [Accessed 2 April 2010]. Country default spreads and risk premiums, 2010. [Online]. Available at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html [Accessed 2 April 2010]. Damodaran, A., 2010. Country default spreads and risk premiums. [Online] Available at: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html [Accessed 2 April 2010]. Dnevnik., 2009. Bulgaria, Estonia among soundest economies in Eastern Europe. [Online] Sofia echo media. Available at: http://sofiaecho.com/2009/03/11/687338_bulgaria-estonia-among-soundest-economies-in-eastern-europe [Accessed 2 April 2010]. Gonzalez-Hermisillo, B., 2008. Investors risk appetite and global financial market conditions. [Online] International monetary fund, P.13. Available at: http://books.google.co.in/books?hl=en&lr=&id=HB6X0PgCZEIC&oi=fnd&pg=PA3&dq=risk+premium+for+Credit+default+swaps+rate+in+bulgaria&ots=GbgXtVzcd8&sig=id8ovWM_KHAC-UelDn85tjBcr-E#v=onepage&q=&f=false [Accessed 2 April 2010]. Kornel kisgergely : what moved sovereign cds spreads in the period of financial turbulence?, 2009. [Online] Google docs, p.3. Available at: http://docs.google.com/viewer?a=v&q=cache:wJXnhy6N5qIJ:english.mnb.hu/Resource.aspx%3FResourceID%3Dmnbfile%26resourcename%3Dstabjel_1_kisgergely_200911_en+Secondly,+if+the+global+component+grows+(declines)+because+international+investors%E2%80%99+financing+position+deteriorates+(improves),+they+reduce+(increase)+their+position&hl=en&pid=bl&srcid=ADGEESgDHky-XMSYKvAF6b3NmsleMz-cxYJWq1pmgI9WVYbXrvkBk6s1UDon40_7q4XGPV3UI2Ap3G-ypnd4Cy09dHRMEku0IT_yMFw4o4JPeLmLc2ln3979V9mRFogqvIbEx5A6Q6sC&sig=AHIEtbTwBJvbPT6GAqhXdxUcqPdOJ5Y6zQ [Accessed 2 April 2010]. Nemethy, L., 2009. Risk premium. [Online] Quantum equity direct. Available at: http://sofiaecho.com/2009/04/30/712166_risk-premium [Accessed 2 April 2010]. Nemethy, L., 2009. Risk premium in central Europe. [Online] Seeking alpha. Available at: http://seekingalpha.com/article/137196-risk-premium-in-central-europe[Accessed 2 April 2010]. Remolona, E.M., Scatigna, M. & Wu, E., 2007. Interpreting sovereign spreads. [Online] BIS Quarterly Review, p.28. Available at: http://www.bis.org/publ/qtrpdf/r_qt0703e.pdf [Accessed 2 April 2010]. Top 100 UK pension funds – how ethical are they, n.d. [Online] Friends of the earth, p.7. Available at: http://www.foe.co.uk/resource/briefings/top_100_uk_pension_funds.pdf [Accessed 2 April 2010]. Wagstyl, S., 2009. Prospects hinge on global markets. Financial Times, [internet] 13 May. Available at: http://media.ft.com/cms/298732f8-3f00-11de-ae4f-00144feabdc0.pdf [Accessed 2 April 2010]. Read More