Freeing capital: swaps versus CLOs
Korea Development Bank's recent launch of a $1.5 billion global bond highlighted the close links between the capital markets and credit derivativese?
The sudden appearance of a liquid reference asset sparked a rush to hedge South Korean country risk. Banks wary of exposures to an increasingly shaky banking system queued to buy default swaps on KDB. Investors - mostly banks - were happy to sell their bonds and re-book KDB risk on the other side of the swaps, earning a 10bp pick-up. But how good a hedge do these swappers have?
Countries can suspend foreign-exchange convertibility without defaulting on a security, so a default-swap hedge would not pay out even though the hedger had lost its commercial position.
In theory, the imposition of currency controls would lower the borrower's credit standing in investors' eyes, which would increase the value of the default-swap position. However, the basis risk involved would be large enough to make the hedge useless. Using a bond as a reference asset exacerbates the problem: even when they have defaulted on loans, countries tend to service Eurobonds.