Back in 2005 and 2006 the market for credit derivatives was best characterized as going through an age of innocence. Spreads were steadily declining and the volatility, albeit fairly high, was remarkably stable. There was only one smaller shock to the system and that was the crisis in the US automobile sector in spring 2005. At that time, I thought that should had been a lesson to learn from but few seemed to agree. In an article written back in 2006 “Back to the Future: Futures Margins in a Future Credit Default Swap Index Futures Market” (The Journal of Futures Markets 27 (1), 2007) I wrote
”Although the General Motors episode [of 2005] might not repeat itself, it should nonetheless be a lesson for the future; whether or not the credit environment becomes riskier over the next couple of years, similar sudden changes in CDS spreads most likely will strike the CDS index market from time to time.”
Today few would argue against the importance of an explicit focus on low-probability tail events in the credit market! Still however, I think few understand the degree of stress the credit derivatives market is under. Therefore, in my new paper The Age of Turbulence - Credit Derivatives Style [available upon request] I try to stress how extreme the movements in the credit derivatives market have become and how multi-sigma credit spread changes have become the name of the day. As an example, in July 2007, every second day saw a 5-sigma iTraxx CDS index spread change. A corresponding return history in the US stock market (S&P500) would be a sequence of 11 extreme July-returns in S&P500 of -9.1%, -6.5%, -4.1%, -3.9%, -3.4%, 3.4%, 3.6%, 4.3%, 5.5%, 7.4% and 8.6%. In July only!
Basically, I think July 2007 will be to the credit market what October 1987 has become to the equity market!
