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Elliott insured against Caesars' collapse
The insurance policy
Elliott owned a pile of Caesars bonds. To hedge the risk, it bought credit default swaps, an insurance policy that goes up in value as the bonds fall in the portfolio. The closer a bankruptcy gets, the more the protection is worth.
Who sold the swaps
The sellers on the other side were investors who figured a bankruptcy was impossible after Caesars' latest infusion of cash. They sold short-dated swaps, which doubled down on the long position they already held. As the bankruptcy came closer, what they had sold became more valuable to the buyer.
Shifted incentives
Holding that hedge changed what Elliott wanted. Someone insured against bankruptcy feels differently about the outcome than someone who has doubled down on being long, and those differences shaped the alliances and the chess moves each side made.
Whoever declares bankruptcy freezes every position, like someone yelling Uno. Elliott came out of the freeze with a billion-dollar windfall on its Caesars debt.
How does a credit default swap pay out?
The buyer pays the seller a regular premium. If a credit event happens, such as bankruptcy or a missed payment, the seller compensates the buyer for the loss on the bond, often at a recovery price set through an auction. The market's standard contract terms are published by ISDA. ISDA stands for the International Swaps and Derivatives Association.
Why does a swap gain value near bankruptcy?
A swap's price reflects the market's estimate of default risk. As bankruptcy looks likelier, the premium for new protection rises. A contract bought earlier at a lower premium is then worth more than it cost. Premiums are quoted in basis points per year of the amount insured.
Why would anyone sell bankruptcy protection?
Sellers collect premiums as long as no credit event occurs. A seller who thinks default is unlikely sees the premium as nearly free income. Short-dated swaps expire sooner, so the seller is exposed for less time. Payouts begin only if a credit event actually happens.
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