Wednesday, August 19, 2009

Naked CDS and Shorts

I have talked about Naked CDS many times on this blog. Legislation is now being proposed to curb the use of these instruments.

One of the arguments coming from the crowd that believes all legislation is bone-headed is that "would you ban naked/covered shorts as well?". I believe the two constructs are not equal and should not be compared.

Naked CDS is 4 times the non-naked volume. In other words when a debt defaults the payments needs to be 400% of the nominal value of the debt (assuming all debt is hedged).

Let's say the short interest in a stock is 40% (high). When the stock goes to zero with default on debt, the cash that needs to be ponied up for the short portion is 40% of the nominal of the equity.

If debt is 1 and equity is 1 then the impact of a naked CDS is 10 times bigger.

Naked CDS truly are dangerous instruments that should be heavily regulated.

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