Russias failure to pay bond interest triggers credit default swaps International derivatives panels decision paves way for $2.5bn of payouts on insurance-like contracts Tommy Stubbington, Financial Times, 2nd June 2022 Russias failure to pay a slice of interest on one of its bonds will trigger $2.5bn of insurance-like contracts used to protect against debt defaults, according to a panel of derivatives dealers and investors. The ruling by the Credit Derivatives Determinations Committee that a failure to pay event has occurred pushes Moscow one step closer to a historic debt default, as western sanctions that followed president Vladimir Putins invasion of Ukraine choke off its ability to make payments to US and European investors. Moscow appeared to have dodged the long-expected default on its foreign currency debt when it belatedly repaid investors in early May, just before the end of a grace period on two payments originally due on April 4. But Russia did not include $1.9mn of interest accrued during the 30-day period, prompting some investors to ask the international committee to rule on whether a default had occurred. Wednesdays decision means holders of Russian credit default swaps will receive a payout, with the size to be determined by an auction process of Russian bonds. JPMorgan estimated last month that there was about $2.5bn of CDS to be settled, including deals tied directly to Russia and others based on a basket of issuers. US bond-investing giant Pimco was among the investors with exposure to Russian CDS, having amassed a derivatives wager that Moscow would not default, worth at least $1bn at the end of 2021, according to a Financial Times analysis of the asset managers holdings. The small size of the accrued interest payment, along with the fact that Moscow repaid the principal of the bond due in April, means the decision will not trigger a wider default on Russias debt. However, most investors think an official default is now only a matter of time after US authorities last week ended a sanctions exemption that allowed American investors to continue receiving Russian bond payments. It looks like we have a default, at least for the purposes of CDS, said Marcelo Assalin, head of emerging markets debt at William Blair. A broader default on Russias bonds is still an open question, but it seems likely that will be confirmed with upcoming interest payments. Once a default is confirmed, holders of Russias $38bn of dollar and euro- denominated bonds could potentially vote to demand immediate repayment and start legal action to try to recover their investment. A default could be confirmed on June 26, when a grace period for two payments due last week expires. The Kremlin has revived an earlier plan to make payments on its foreign-currency debt in roubles after the change in US sanctions last week blocked it from paying investors in dollars.

Required: (a) Assume that you are a hedge fund manager and have invested in $1,000,000 worth of Russian government bonds one year ago and have decided to hedge the credit risk of these bonds at the time. Formulate a creative solution to hedge the credit risk of this reference entity. Analyse how you can be protected from credit risk based on such a strategy and possible drawbacks. (350 words) (8 marks) (b) What are the implications of speculation using credit default swaps in the context given in the above article, to the broader society and economy? Provide examples where necessary. (350 words)