Andy Warhol would be happy

David Reilly at Bloomberg notes that the pricing of credit default swaps on both the US government debt and Campbell’s is the same…

Here is the link. Hat tip goes to TheBrowser.

Warhol_campbells-soup

Comments

There's something wrong in the logic of this article. The authors argue that insurance on JP Morgan debt might sell at a premium because the failure of JP Morgan might be associated with a broader economic meltdown, making it especially "costly" for the seller of the swap to pay. But the heightened risk that the swap seller will be insolvent -- and hence unable to perform -- at the same time that JP Morgan defaults should reduce the swap buyer's willingness to pay, not increase it. In other words, the correlation between the insolvency risks of JP Morgan and the swap seller should cause the default swaps to sell at a discount, not a premium.

I shouldn't have written "at any price". In the fat-tailed scenario (which seems to be the efficient market scenario), an insurance contract with a price attractive to both the seller and the buyer does not exist. No one can rationally expect to profit from holding a portfolio of hedges, so the market does not support a professional insurance business. Obviously, I'll buy a default swap for some price. I'll take one for nothing for example, but the swaps can't profitably exist at this price.

Insurers can always gamble, of course, and some insurers might become incredibly wealthy, but none can rationally expect to earn a profit, so holding default swaps in a capital market with a fat-tailed yield distribution is like playing a slot machine.

I'll buy a default swap for some price. I'll take one for nothing for example, but the swaps can't profitably exist at this price.

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