Shamelessly stolen from Levine’s column today:
That $27 million is not the total cost of protection; it is the running cost of protection. Here’s his explanation:
In February, the Pershing Square funds purchased credit default swaps (CDS) on various investment grade and high yield credit default swap indices, namely the CDX IG, CDX HY, and ITRX EUR. At the time of purchase, the IG or investment grade indices were trading near all-time tight levels of about 50 basis points per annum. The high yield index, the CDX HY, was also trading near its lowest spread ever. When one adjusts for the fact that a number of companies in the high yield index were on the brink of default (and these near-default companies’ spreads were in the thousands of basis points), the spreads on the rest of the companies in the index were actually well below the 2006-2007 all-time lows. …
This is best understood by a somewhat simplified example: assume you purchase $1 billion notional of CDS on the IG index for 50 basis points. In summary terms, you are committing to pay 50 bps times $1 billion, or $5 million of premium per annum for five years. Assuming you sell the CDS a month after purchase at a spread of 150 basis points, you would receive approximately the present value of the spread, in this case 100 basis points per annum, times the $1 billion notional amount of the contract for the remaining 4 years and 11 months of the contract’s life.
The present value of 100 bps for 4 years and 11 months is a number which is slightly less than the present value factor times 4.92 years times 100 basis points times $1 billion, or approximately $45 million. Since the contract in this example was only outstanding for one month, the total premium paid would be 1/12th of the annual payment of $5 million or approximately $417,000. Therefore, for a total outlay of $417,000, you would make $45 million. This understates your actual risk, however, because if spreads were to narrow during that month, you would lose substantially more than the premium. That said, if you were confident that spreads would either stay the same over the next month or widen, you would only be risking the premium of $417,000.
Oversimplifying somewhat, Ackman didn’t agree to pay $27 million for a huge hedge; he agreed to pay $27 million per month for five years for the hedge. In the event, it moved so dramatically in his favor so quickly that he was able to terminate at a huge profit in less than a month. If it had taken another month, presumably he’d have kept the bet on and paid another $27 million and the trade would still look amazing, though not quite as amazing (50x return). If in fact we had moved into a new golden age of corporate credit, and spreads had tightened, he might have had to pay hundreds of millions of dollars to terminate the trade. I take his point that, when he entered the trade, spreads were at all-time tights and that risk seemed low, so it was asymmetrically attractive, but, you know, those were the market rates; lots of people lost a lot of money over the last decade betting that rates couldn’t get any lower. In any case, though, the $27 million and $2.6 billion are sort of apples-to-oranges amounts; Ackman got into the trade with a small cash payment and a larger mark-to-market risk, though he got out of it with a much larger mark-to-market gain.
I found that pretty interesting. It’s still a phenomenal trade but less “I bought this one lotto ticket and made bank” and more “I bought an insurance policy for crashes that I would pay premiums for over the next five years and my house got destroyed the next month”
Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.