From Mr Luis Arenzana.

Sir, Of all the articles your newspaper has published on the crisis at hand, none has shocked me more than George Soros’s poor grasp of the risks in credit default swaps positions (“The game changer”, Analysis, January 29).

Mr Soros tries to make a symmetrical case to equities but unfortunately he is wrong when he says a long protections (short credit risk) position has unlimited upside. It doesn’t. The largest pay-off for that position is to make the nominal amount of the swap (assuming there is zero recovery value), analogously in a short protection (long credit risk). The maximum loss is the nominal amount of the swap (again assuming zero recovery value).

The market in CDSs or in any other swaps requires a seller of risk for every unit of risk bought. In other words there are no more short sellers of risk than those accommodated by takers of that risk. There is no naked short-selling possibility.

Who are the speculators then? Those who were buying protection on Lehman often to hedge their counterparty risk; or those who were selling the protection while thinking that the Fed and the Treasury would bail them out as they had in the past?

Mr Soros then goes on to say that the price differences (probably he refers to credit spread differences) between the cash market and the CDS invalidate the Efficient Market Hypothesis. I would not want to come out as defender of that theory (or any other in financial economics) but a simple reason for this phenomenon is that the credit spread difference (called the “basis”) between the cash market and derivatives is usually explained by the availability anControl Paneld the cost of funding positions (or the lack thereof in this case).

Cash bonds were cheap relative to protection and have been getting cheaper as the deleveraging progressed. This widening of the basis was a very significant contributing factor to recent hedge fund losses.

Luis Arenzana,
Madrid, Spain