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Not sure which direction the Sensex will take?

You can take a look at the ICICI Bank CDS spreads to find out where the stock market barometer is headed.

Credit default swap (CDS) market is generally a lead indicator for the direction of equity markets. The reason that equities and other risk assets including currencies follow the CDS market is because CDS traders are the quickest to react to the markets that is, either move in or pull out.

CDS is mostly an unhedged derivative game, where players buy and sell protection on credits without any natural hedges behind them. At the end of 2007 the CDS positions outstanding globally were $58 trillion, which came down to $42 trillion at the end of 2008, as per the Bank of International Settlements, post the credit crisis bust. Total world debt at the end of 2007 was around $95 trillion, which if interpolated with CDS outstanding of $58 trillion, implies that every second debt outstanding was hedged. This, of course, is not true and it would be reasonable to assume that more than 75% of outstanding CDS trades were speculative and not hedged with underlying bonds.

Closer home, ICICI Bank CDS, which trades in the Hong Kong CDS market where all Asian credit trades, has given good leads on the direction of the Sensex. The sharp rise in CDS spread on ICICI Bank from levels of 60 bps in the beginning of 2007 to 200 bps in end-2007 pointed to a rising global risk aversion.

The Sensex, which peaked at end 2007, started following the rise in ICICI Bank CDS spreads in 2008, by falling steadily from peaks.

The height of the crisis saw ICICI Bank CDS spreads go up to 1,600 bps levels and the Sensex falling by 50% from peaks.
Recently, ICICI Bank CDS spreads rose from 240 bps to 420 bps in the July-December 2011 period. The rise in credit spreads was accompanied by a fall in the Sensex and the Indian rupee by over 15% each. Credit markets were quick in spotting the risk to ICICI Bank credit on the back of the sovereign debt crisis in Europe and also domestic issues.

ICICI Bank is favoured by regional CDS traders to air their views on credits. The bank has dollar-denominated bond outstanding of around $8 billion and is a well accepted credit by global investors.

ICICI Bank bonds are also seen as the most liquid of Indian dollar-denominated bonds. In a sense, ICICI Bank CDS acts like an Indian credit index, which is amplified as speculative activity increases. If India is in or out of favour with the markets, it gets reflected in the ICICI Bank CDS spreads.

The CDS spread levels itself may have nothing to do with the underlying credit quality. ICICI Bank is rated AAA in local currency ratings and carries a higher rating than the Indian government in the foreign currency ratings. The sharp rise in ICICI Bank credit spreads in the recent past is seen as India going out of favour with the markets.

CDS is a derivative that transfers credit risk from one entity to another. The seller, also called the protection seller in the transaction, assumes credit risk from the buyer, also called the protection buyer.

The seller receives annual premiums (in bps) from the buyer for taking on the credit risk. The buyer, in turn, receives full payment from the seller in the event of default. A rise in CDS spreads indicates bearishness on credit, while a fall in CDS spreads indicates bullishness.
The writer is the editor ofwww.investorsareidiots.com,
a website for investors