A deal too good to miss? Wednesday, March 19, 2008
The panic in financial market is causing violent swings in prices. At the top and bottom of these, apparently even cautious investors are starting to re-enter the market to take advantage of the overshoot and comparative value implied.
For instance, the price of a 5 year Credit Default Swap on iTraxx Europe hit than 160 basis points this week. This means anybody selling protection on £10m would earn £160,000 a year. Of course, you face the potential of paying out £10m were the index constituents to default. However, if you believe that prices are very frothy and will return to levels consistent with the past, then you could close you CDS position out as prices fall i.e. you receive £160k today but if you can cover this risk in a month's time for say £140,000, then you have a clear £20k profit.
Similarly, the credit spreads on some banks such as HBOS and Lehmans, were at levels typically associated with Nigeria. In comparative value terms, does that make sense?