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Pricing of the premium, which is essentially the price of the default risk of the bonds, will be a major task. In established markets, the price for a unique risk in an instrument is derived from the supply and demand for the risk in the market. For example, in equity markets, there is a liquid plain-vanilla options market where option prices are generated via supply and demand by investors. The volatility parameter is actually derived from the prices of the plain-vanilla options to price other illiquid instruments. Similarly, in the credit market, with a liquid credit default swap (CDS) market in place; default probabilities are derived from the prices of the CDS. It has been established in research studies that the CDS market gives out the most reliable default probabilities compared to the bonds market, due to its better liquidity. Without a market that trades the default risk in Malaysia, the Agency will have to theoretically derive the credit risk pricing. This measure may well expose the Agency to various open questions like the acceptability of the model used, any judgemental perimeters applied and the robustness of the pricing model. The main issue here is that the risk is priced remotely and it is not very likely to be aligned with the market. Another potential issue is defining the credit event. Would it include failure to pay coupons and restructuring events, or is it purely confined to bankruptcy events? Multiple events of defaults may further complicate the theoretical pricing of the default premium. And Credit Default Swaps (CDS)? Credit default swaps, which are over-the-counter instruments of the 1990s and early 2000s, were indeed unregulated instruments, an outcome of a few regulations in the U.S. such as the Gramm-Leach-Biley Act, 1999 that exempted regulation for certain OTC instruments like the CDS. The lack of transparency on the CDS further propelled the significant amount of leverage taken by major financial institutions that contributed to a web of inter-connectedness, which induced massive systemic risk into the financial system. However after the 2008 crisis, the CDS is being re-invented as an exchange traded product for those with common names and maturities that can be easily standardized. For the more illiquid names and structures, central clearing houses and swap execution facilities are being put in place, albeit with a number of teething issues to be tackled with.
Conclusion The proposed Credit Hedging Agency initiative is a noble move that hopes to attract investors to trade in lower rated bonds. It is not a tradable product like the CDS, but rather a hedging service with a fee. The survivability of the business model will very much depend on its default premium and volume of business. Meanwhile, we should also pay attention to the enormous effort being put in globally to make the CDS a safer and transparent product.
As a final point, perhaps we need to probe deeper to find out what exactly is the cause of such lack of appetite in subscribing and trading for lower rated bonds, in comparison to other countries. Lower rated bonds attract investors with a different risk profile, compared to higher rated bonds. These investors are willing to accept the higher coupon and take higher risk as they have higher mandate to take more risk. They could be hedge funds and even private equities, but to a large extent, this market consists of bond traders who typically buy and sell bonds for profit, like shares. They often form part of an investment bank activity and make proprietary profits for the bank. Do we have enough of these bond traders in Malaysia? In spite of everything, it is always traders that make a market, not long-term investors.