Aswat Aksir Mujib Wasi.

Vice President
National Bank Limited.

April 14 , 2020

An American Hedge Fund Manager who Turned 26

Million into 2.6 Billion in Days by Predicting a
Pandemic.

The story of Bill Ackman, who predicted the effects of the COVID-19
pandemic on U.S markets.

Bill Ackman, Founder, and CEO, Pershing Square Capital Management

Source : Bloomberg
How might somebody transform millions into billions in simply an issue of days? This article covers the
story behind how an American Hedge Fund Manager, Bill Ackman did this by utilizing a monetary
instrument called Credit Default Swap (CDS). Those of you who have followed the 2008 monetary
emergency or otherwise, the global financial crisis of 2008 may have heard this word previously.

What is a Credit Default Swap (CDS)?

A Credit Default Swap is like an insurance contract where the Insurance buyer pays a premium to
the Insurance seller for protection against default of a particular asset which has been insured.
The key difference between the two is to buy simple insurance, the asset must be owned by the
Insurance buyer but in the case of a CDS, it need not be the case.

A Visualization of a CDS. Source: Google

Let’s take a look at an example:

Assume you have a 5-year bond of a company whose principal value is $5000 and the interest rate (also
known as the coupon rate) is 8%. You are worried that even though the company is in a good position,
there might be a chance that it will default on your payments. Being a risk-averse person, you would
prefer to reduce this risk. So to do this, you would use a CDS.
So how does a CDS help insure the money you lent?
To get a CDS, you go to a bank (there are other entities that sell CDSs as well) and buy a CDS on the
bond of the company. Now, why would a bank like to take this risk (known as the Credit Risk). As
there’s no free lunch, the bank is not going to take the risk for free but will charge you a premium for it.
Usually, it is expressed in terms of basis points. Here higher the risk of default, the greater the premium
for it.
The Company on whose bond you have purchased a CDS is known as a Reference Entity and the event
when the company defaults on its payment is known as a Credit Event.

What’s Next?
Therefore, now after you bought a CDS there are two scenarios that can take place.

1. The Reference Entity doesn’t default on your payments

In this case, the bank does not have to pay you anything and it pockets all the premiums paid so far.
2. The Reference Entity defaults on the payment (Credit Event).
This event would cause the buyer of the protection to terminate the contract and the seller must settle the
remaining payment which may be either physical or cash-settled.

How did CDS help in making money during the COVID-19

Pandemic?
So, coming to the interesting part, how did an American Investor turn his funds’ millions into billions
using these Credit Default Swaps?

Bill Ackman
To give a concise presentation about him, Bill Ackman is the founder and CEO of Pershing Square
Capital Management, a hedge fund management organization. Known for his contrarian position, he had
lost his cash on two bets in ongoing past-One being on a drug manufacturer Valeant Pharmaceuticals
International Inc. in which he lost about $4 billion and the other one was on Herbalife where he wager
against it however the stock shot up and consequently ended up costing him a fortune. Both between 2015
and 2019. In the following excerpt from his letter to investors, he explains his rationale for buying CDS.

We had acquired large notional hedges that have asymmetric payoff characteristics; that is the risk of the
from these hedges was limited, while their potential upside was many multiples of our capitals at risk. We
believe that efforts to contain the coronavirus are likely to have a substantial negative impact on the U.S.
and global economies, and on equity and credit markets.’- Bill Ackman.

Basically, he wanted to hedge the holdings of a company that included significant chunks of restaurant
and hotel stocks, which were going to take a hit during the impact of coronavirus on the U.S Markets. He
felt the protection available on this was cheap compared to potential profits.

Ackman noted that the investment-grade indexes were

trading near their all-time tight levels, at about 50 basis
points a year, and the high-yield indexes were trading
close to their lowest spreads ever. Pershing bought the
swaps because he expected them to rise in value as
sweeping lockdowns in response to coronavirus widened
credit spreads and reduced stock prices, he said. —
Markets Insider March 27, 2020.

The spread of a CDS is the annual amount the protection buyer must pay the protection seller over the
length of the contract, expressed as a percentage of the notional amount.

The sell-off in the market widened the spread ( Increased risk = Increased premium) driving up the value
of the Credit Default Swaps to about $2.7 billion by March 12, 2020, while the premiums paid on these
were only about $25 million. Ackman then started squaring-off his positions and ended up with a profit of
$2.6 billion by paying premiums worth $27 million only. Even though he made quite a fortune on his bet,
his profits were offset by the losses on his portfolio due to the COVID-19 pandemic.
Now coming to the controversy surrounding the trade. Some people and critics accused him of
manipulating the markets through his tweets and his interview on CNBC. He was accused of deliberately
causing panic resulting in a sell-off. On the other hand, it can be argued that he was just sharing his views
regarding the pandemic and its negative implications.

One of the tweets for which Bill Ackman was accused of manipulating the markets.

Further, people tend to forget that by taking up these trades, hedge fund managers are exposing
themselves to a huge amount of risk as well.
‘If this trade hadn’t worked out we’d lose about $25million in a month’- Bill Ackman told this while he
was being Interviewed by the WSJ.
The $25 million paid as premiums is no small amount. In this case, he took a calculated risk and it turned
out to be in his favor.