A whole bag of questions to see us through the weekend.
Question 1. If I buy a corporate bond and buy a single name CDS written on the same bond, is it possible to earn a spread even though someone else is taking the default risk?
CDS is a form of insurance against default. So if I buy a CDS on a single name, I am insured against loss on default for the name. If I buy a bond for that name, I take that default risk, but if the spread on the bond (which is meant to compensate for that risk) is higher than the spread implied by the CDS, then of course I can earn the difference.
Indeed, there is evidence that bond spreads exceeded CDS at the heart of the financial crisis, but no one really understands why. However, after the crisis it turned the other way round, and (from memory) CDS spreads exceeded bond spreads. So if we want to estimate MA now (as opposed to during the crisis) it would be negative, not positive.
We can always earn a difference, if it exists, but what is the sign of the difference?
Question 2. Isn’t the rationale for discounting at risk-free that it allows a firm to “close-out” its position – the firm has enough money to allow it, if it wants, to adopt an investment strategy that guarantees that liabilities will be met?
The rationale is about the correct value of the liabilities. A perfectly hedged position has no value in any possible future state of the world. Whatever the cashflow of the asset in scenario X, the liability will have an equal and opposite cashflow, so the total is zero. Hence the value of the hedged position is zero, hence the present value of the liability must equal the present value of the asset. But we can only ensure that the position is perfectly hedged if the asset is risk free. Therefore the present value of the liability is its future value discounted by risk free. This reason has nothing to do with the ability to close out.
It is sometimes argued that the market is irrational and that short term volatility is ‘artificial’, so the close out cost will be greater on account of the artificial volatility. But as we have argued before, even if true it makes no sense to base our capital model regime on such artificial volatility (e.g. by constructing distributions of artificial historical returns). And is it even true? The market may be irrational, but how do we spot the points where it is irrationally low or irrationally high? How do we operationalise a procedure for speculating on the irrationality? Better people have tried.
Question 3. https://www.bis.org/review/r180511d.pdf says ‘[The Matching Adjustment] is calculated indirectly as a residual by subtracting from the yield on an asset (1) risk-free rates and (2) an estimate of the required premium for risks to which insurers are exposed.’ Are you essentially saying that insurers companies are generally (and significantly) under-estimating the required premium for risks to which they are exposed?
What we are essentially saying is that it is improper to book any excess returns over the available risk free rate (on sovereign bonds etc) in advance of waiting for them. The BBC documentary explained this very well.
28:40 DB: If you then go on to sell your insurance company, you have then made two billion pounds out of nothing, effectively, via the matching adjustment. If the customer questions that and says, well hang on are all these books correct you say well, you know, look here it’s got a PRA kitemark of approval. The PRA has approved our model.
29:00 H: [racecourse sounds] I tried this idea out at Leicester racecourse with Neil our bookie. He didn’t like it. [To N] ‘What would happen if the rules changed so that the people who make the rules decided that you could pay out for me and a few of my friends if we have this level of certainty’?
N: Well you can’t possibly know it’s really going to win. So there’s absolutely no point in me giving your money before the race, because it might not win. There’s no such thing as a racing certainty. Despite any rules [laughs].
The spread over risk free reflects a lack of complete certainty, so you can’t collect your winnings in advance, by e.g. creating equity via the MA and paying it to shareholders as dividends, or selling the company. This essentially defrauds prospective shareholders, who are paying, and taking a risk, for a return they will never receive.