 Quote:
Originally Posted by boont
"Derivatives, such as credit default swaps also create major distortions in the traditional indicators of value of stock and bond markets. Many people wonder, for example, why the indices, like the DJIA, S&P500, etc., seem to go up endlessly. Part of the reason is that big institutional investors no longer sell companies they feel are about to fail, no matter how obvious that impending failure may be. The securities, issued by such companies, may retain significant paper value, up until almost the very end. Instead of selling, investors can buy "insurance", in the form of derivatives, and keep holding their investments. This distorts the value of traditional market indices, because the decision to remove a failing company from the index, can be made well before the paper value drops to zero. This saves the value of the index. It creates the false impression that the index always rises. "
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This is wrong on several fronts. The most glaring problem is the idea that an institutional investor can simply buy default insurance on a company "no matter how obvious an impending failure may be." The price of a CDS contract will reflect the "obvious impending failure" and be prohibitively expensive. Would you be willing to sell default protection on a company that was facing "obvious impending failure"? Well neither would other investors, without adequate compensation. Also, CDS trades impact the market prices of cash bonds they are designed to protect, and vice-versa. If they didn't, arbitrage profits would be available.
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