What the credit default swap market tells us... - Outside View by Asad Dossani

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What the credit default swap market tells us...
May 31, 2011

The Credit Default Swap (CDS) market is one of the largest over the counter derivatives markets in the world. A CDS can be though of an as insurance contract on a bond. The owner of a CDS for a particular bond receives a payout in case the bond issuer defaults.

The pricing of CDS can be quite involved, but in general we can interpret a higher CDS price as a greater probability of default. That is to say, the more likely a default is, the higher will be the cost of insuring against a default. CDS contracts trade for all types of bonds, and some of the biggest markets are in sovereign bonds. These are insurance contracts on government bonds.

With all the talk about sovereign debt crises and potential defaults, the sovereign CDS debt market can provide us valuable information as to what the market believes about future defaults. Based on some data on the prices on five-year CDS contracts, Greece currently has the highest CDS price - meaning that it is more likely to default than any other country. This is not much of a surprise.

The 5 countries with the highest CDS prices and most likely to default are: Greece, Venezuela, Portugal, Ireland, and Argentina. This again is not much of a surprise. The 5 countries with the lowest CDS prices and least likely to default are: Norway, Sweden, Finland, Denmark, and the Netherlands. This is somewhat surprising. Certainly, these 5 countries all have a very low likelihood of default. What is surprising is that the US is not on this list.

Prior to this year, the US had the lowest CDS price - meaning its probability of default was lower than any other country. Today, they are no longer in the top 5 - their CDS prices have increased 20% in 2011. In contrast, with the exception of the peripheral Eurozone economies, most other major economies have seen a fall in their CDS prices, and a reduction in their default probability.

The rise in US CDS prices can be attributed largely to the political situation in the US. Democratic and Republican congressmen are unable to agree on raising the US debt ceiling - something that is necessary or the US will default. There is not concern that the US is actually unable to meet its debt payments. The concern is based on political factors that could trigger a default. While it would be difficult to imagine that politicians would let a default occur, the market certainly has recently believed that this is entirely possible.

On the other side of the spectrum, Greece has the highest CDS price and greatest probability of default. At current prices, the market is expecting a Greek default to occur in the next few years. It is not a question of if, but a question of when. The CDS price has remained high despite the bailouts Greece has received. This is a very strong indication that Greece will need to restructure its debts in the future. It is proof of something we already knew: taking out new debt to pay off old debt is pointless if you are already insolvent.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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