Loss Potential from Credit Derivative Use by Corporate Bond Funds under U.S. and German Regulation – A Cross Country Comparison

Abstract

Abstract This study analyzes the loss potential arising from investments into CDS and CDS use-induced risk and performance implications for a sample of large U.S. and German mutual funds. For several funds in the U.S., the regulatory potential losses arising from selling CDS protection are almost as high as net assets, while in Germany, this potential can be even higher. As opposed to the U.S. funds, German funds face a higher risk exposure, i. e. standard deviation and idiosyncratic risk, and suffer from worse performance due to the enormous selling of credit protection during the crisis. Furthermore, additional analysis of the CDS trading activity of German funds between two consecutive reporting dates suggests that period-end data overlooks many round-trip CDS trades (purchases followed by sales or the other way around) undertaken by management. Thus, funds are able to circumvent the direct leverage restrictions, which limit bank borrowing to 10 % and 33.3 % of net assets in Germany / the EU and the U....