Thursday, November 03, 2011

Risk of Credit Default Swaps (CDS)

Suppose you bought Greek bonds and to protect yourself against default, you bought a CDS and paid a premium for this protection. The Greek government now offers repayment with a 50% "haircut" (i.e. you suffer a 50% loss) and you wish to make a claim on the CDS. Will you get paid for your loss?

According to this article, you will not be paid, as this is called a "voluntary settlement". On the other hand, there are many investors who were on the other side of the CDS during the Lehman crisis, and they lost all of their investments. It is "tail they win, head you lose".

Lesson: Avoid all types of complex instruments. Just invest in the STI Exchange Traded Fund or in blue chip share". Attend the FISCA Financial Planning talk - http://easyapps.sg/assn/Org/Event.aspx?id=5


7 comments:

Anonymous said...

Dear Mr Tan
May I commend you for your patience in advising Singaporeans on the risks of all these fancy financial instruments.

May I just add that most financial derivatives are also legal instruments. It is contractual in nature. So unless you can find and afford a lawyer who is also competent in these derivatives, a retail investor is likely to lose in a dispute.

A bank can afford a team of high priced legal talents. What can we as retail investors afford? No point bringing a knife to a gunfight.

Also retail investors must ask ourselves whether we are investing in a business environment that is sympathetic to the small investors. "Know yourself, know your enemy, a hundred battles, a hundred victories."

Not all derivatives are bad. Standardized derivatives contracts like the stock options traded in USA have very well established rules & regulations.

Anonymous said...

No blue chip shares will survive the impending financial apocalypse.

It's started with Greece default, follow by breakup of Eurozone. Next will be US and the rest will be history.

And the occurrence of natural disaster that affects food & energy resources adds to the impact of this monumental crisis, a double whammy.

Blue chips or potato chips, you choose.

Tan Kin Lian said...

@11:57 am
We will still need business to manufacture and distribute products and services, so legitimate business will continue to have a role, even in the world that has melted down. Blue chips represent these businesses. While the share price may collapse in the near term, they will recover after the turmoil and will be all right for the long term - 10 years or longer.

Anonymous said...

Why wait for 10 years or more to realised any potential investment gain if you know that a crisis looms overhead and prices of blue chips are going lower?

Why catch falling knifes when you can be throwing knifes at so many sitting ducks now?

Anonymous said...

Greece should be thrown out of the union. It may be painful initially to kick it out but makes no difference in the long run

Anonymous said...

I agree with TKL on blue chips. But I am taking a bigger world view and had started investing in "international" blue chips during 2003 up till today. These are actually big companies mainly in US, but have 50% of more of their revenues from international markets including emerging markets.

These companies are dividend aristocrats that have *increased* their dividend payouts over 25 years or more (not just paying dividends). Many of these companies survived and thrived thru World War 2, continuing to pay out dividends without cutting dividend payouts. During 2008/2009 stock market crash, these companies actually *increased* their dividends. After 10-15 years holding period, you are getting 10+% dividend yield on your original investment cost, and the yield still keep on increasing as these companies continue to churn huge cashflows and increase their dividend payouts.

The problem is that at any point in time, when you buy these companies, their current dividend yield is usually only about 3%. The trick is to hold them for long term. Why do you think Buffet still keeps holding onto Coke??

Actually many of you will be familiar with these companies' products as many are consumer staples --- your family buys them weekly, daily at supermarkets, use and consume them, for eating, household products, smoking, drinking, over-the-counter medications etc etc. But you may not be familiar with the controlling companies. Just take a look at the labels and fine prints on the packaging.

The only problem is that officially there's like 70% estate tax on US stocks as a foreigner. I know there're like insurance-type portfolio bonds in which you can insulate yourself from US estate tax, but the maintenance cost can be 1% or 2% per annum.

yujuan said...

Looking at Europe's and US economic woes, gut feeling says the markets have not bottomed yet.
Perhaps it's wiser to follow TKL's advice to invest in STI ETF first when there's a correction, and leave the blue chips aside for next year. Some people commented Warren Buffet is talking the market up for his own selfish interests in his share portfolios, so best for one to invest according to his time horizon.
Right now, I guess Cash is King.

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