Question

1. Explain the concept of the yield curve for bonds and distinguish between the expectations theory and market segmentation theory of the term structure of interest rates.                                                       

Discuss the role of Credit Default Swaps (CDS) in transferring the default risk on corporate bonds, in the context of Global Financial Crisis 2008.

Answer 1

Yield Curve for bonds

The yield curve is a graphical representation of the interest rates on debt for a range of maturities. It represents what an investor expects to earn by investing over the period of time.

Expectation Theory VS market segmentation theory:

Expectation theory: It is also known as “unbiased expectations theory”. This theory attempts to predict what short term interest rates will be in the future based on current long term interest rates. This theory helps the investor in making decisions based upon forecast of future interest rates.

market segmentation theory: This is a theory that says long and short term interest rates are not related to each other. It also states that prevailing interest rates for short and long term bonds should be viewed seperatly like items in different markets for debt securities.

Credit Default Swap

CDS is a type of credit derivative that provides the buyer with protection against default and other risk. The buyer of a CDS makes periodic payments to the seller until the credit maturity date. In the agreement seller commits that, if the debt issuer defaults, the seller will pay the buyer all premiums and interests.

Before the financial crisis of 2008, there was more money invested in credit default swaps than in any other pool. The value of credit default swaps was $45 trillion compared to $22 trillion invested in the stock market, $7.1 trillion in mortgages and $4.4 trillion in U.S treasury. In 2010, the value of outstanding CDS was $26.3 trillion

Many investment banks were involved, but the biggest casualty was lehman brothers investment bank, which owed $600 billion debt, out of which $400 billion was covered by CDS. The bank’s insures, the American insurance group lacked funds to clear the debt and as a result federal reserve of the united states needed to intervene.

Companies that traded in swaps were battered during the financial crisis. Since the market was unregulated, banks used swaps to insure complex financial product. Investors were no longer interested in buying swaps and banks began holding more capital and becoming risk averse in granting loans.