Credit default swaps (CDSs) have a really bad reputation following The Big Short. Both the book and the movie detail how, in the mid-2000s, indulgent financial practices resulted in highly levered and risky derivatives that were mispriced and misunderstood. An increasingly popular attitude towards derivatives has been that they are all toxic, unproductive, and perhaps shouldn’t even be legal.
Derivatives’ reputation aren’t helped by famous and publicity-hungry Warren Buffett, who have called derivatives “weapons of mass destruction.”
If this sounds to you like value investors hate derivatives and avoid them at all costs, don’t be fooled. Buffett has used billions of dollars worth of derivatives throughout his career, such as when he sold $195 million of derivatives in 2016 or when he bought billions of options on Goldman Sachs in 2009. Buffett not only uses over-the-counter (OTC) derivatives, but very often will make deals with business owners to buy or sell custom-made options, futures, and other derivative products.
If derivatives are financial WMDs, Buffett is Dr. Strangelove.
For the casual observer, however, Buffett’s folksy wisdom combined with the memories of 2008 make for a compelling case that derivatives are terrible things, although the reality is much more complicated. For instance, the average American may be shocked to learn that their health insurance program is a financial derivative (specifically, it’s a put option on your own health). Insurance is by definition a kind of derivative because, in reality, derivatives are by definition types of insurance.
A call option is a contract to buy an asset at a future price; as such, it can be used as a hedge against being short the position. Put options, similarly, act as hedges to being long a stock by giving you the option to sell at a certain price. While these options are often used as speculative instruments in financial markets, they are also often used as hedging instruments to protect portfolios from excessive losses.
CDSs, despite their reputation, function in the same way. As an insurance against the buyer of a bond potentially losing money on that bond, buyers of a bond can buy CDSs to hedge their exposure to that bond. They can also trade those CDSs as part of an overall portfolio to limit exposure to the variety of risks that bonds are exposed to (credit rating, interest rate, currency, etc.). The management of a portfolio of CDSs alongside a portfolio of bonds involves complex math, statistics, and expectations both of economic growth and fundamental market changes.
In other words, these products are too boring to be weapons of mass destruction.
When used properly, CDSs are about as exciting as an insurance policy. The real problem is when speculation on future prices of these derivatives becomes too large of a market—or when the CDSs themselves are constructed in a way that is faulty.
Both of these risks were in full force in the mid-2000s, but they are minimal today. Instead, CDSs are used to limit risks in a diversified portfolio. Thus, for instance, a global bond portfolio with some Argentinian bonds may be (rightly) worried about an Argentinian default, since the country has defaulted on its debt more than once in history. The manager can then buy some CDSs that offset the risks of a default which, at the end of the day, may lower overall returns but will also provide a less volatile portfolio and less risk of losses.
Understanding the relationship between CDSs and their underlying assets’ value is complicated, because these are custom structured products. Unlike options, which have a simple and transparent relationship to the assets they derive from, CDSs have a custom structure with a variety of unique covenants and triggers that can impact their value in hard-to-see ways. This is where analysts need to read the prospectuses, think critically about all of the implications of the legal restrictions of the CDS, and bring these to a PM’s attention.
In other words, making CDSs work in a portfolio is hard work of critical thinking and careful analysis. When done well, they can provide superior returns and lower risk for clients, which is why they function and why sophisticated investors and analysts value them far beyond the popular caricature they have received.