Wednesday, March 11, 2009

Default risk vs. Spread risk

Paul Krugman comments on the rising CDS spreads on US government debt:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?
Oh my god, repeat after me: CDS on U.S. government debt are spread products. Protection buyers aren't hedging default risk, they're hedging spread risk. For example, a bank that has a large inventory of Treasuries will want to hedge the risk of a significant deterioration in the value of Treasuries. Since standard CDS provide for daily collateral posting based on the value of the underlying reference obligation(s), protection sellers in CDS on U.S. government debt have to post more collateral when the value of Treasuries declines. Default risk vs. spread risk isn't a difficult or terribly advanced concept, and it's definitely something you should know if you consider yourself to be an "informed commentator" on the bank rescue.


Anonymous said...

Thank you for bringing a fresh thought to this sovereign CDS issue. This topic came up, much in line with Krugman, at the blog Zero Hedge. I wanted to let you know I posted a quote from your post as well as a link to your site in his comment section.

truly agog said...

Just for us uninformed masses - how does increased collateral help someone? Are they then free to loan it back to the CDS writer at interest, so it can be posted again as collateral on Tuesday? Or just to use it as they see fit? Does it have to be returned when the bond rating goes back up again?

So from the point of view of the buyer, if my Treasury looks worse, I get a loan of cash from the writer to invest, and I eventually repay that loan with the proceeds of the Treasury when it matures?

And from the writer's point of view, I get the premium flow, and may have to give it back early? How are premiums figured? How is collateral figured? The insuree would want constant cash flow and principal guarantee. Now I'm stuck on differentiating market interest rate moves (affecting bond value) from bond writer financial strength. Does Moody's now rate the US Treasury? (Geithner should buy them now!)

If you've got the time to walk us through an idealized calculation (5yr maturity; same as CDS duration for starters) I (and maybe Paul K) would appreciate it. ......Please don't tell me it's priced by what the market will bear...

Anonymous said...

This kind of matter Diablo 3 Goldshowed up, much consistent with Krugman, with the website Absolutely no Hedge. I needed to let you know I actually submitted a quote from your publish and a link to your internetRS Gold site in his remark segment.

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