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How Can FX Moves Impact CDS

19 January 2015 by lberuti

The FX market has been the topic of many debates following the dramatic moves of last week after the Swiss Central Bank decided to abandon the Swiss Franc floor of 1.2 per Euro. The dramatic swings that followed in FX land created some volatility on equities and interest rates, but far less so on credit. In fact, the impact of FX moves on CDS are not necessarily intuitive and are often more technical than fundamental. For instance, the companies whose risk premia were the most impacted are companies which have effectively hedged their (big, because they are exporting companies) FX exposure! Companies usually do so by entering derivative products with banks. These contracts are usually not covered by any margin call agreement. So when their market value move against the companies which face the banks, the latter can potentially be owed big amounts of money, creating some credit exposure which the banks will try and hedge. To do so, banks will buy some 5 year CDS referencing these companies, but also shorter dated maturities as some FX derivative contracts expire sooner, and also because shorter dated CDS are less expensive. This results in wider CDS and flatter curves for the companies. That is exactly what you see on the above Grapple, which plots the evolution of the 3 year 5 year CDS curve as a function of the 5 year spread since the beginning of last week (during which the USD kept appreciating vs the Euro). The head of the pins represents the most recent data point. While most pins should point left because of the general move tighter, all the car manufacturers point right (their risk primia have increased) and down (their risk premium curve is flatter).