Posts tagged ‘Credit Default Swap Explained’

Credit Default Swaps (Gauges Solvency of a Country!!)

Credit Default Swap i.e. CDS are a financial instrument for swapping the risk of debt default. It is similar to Insurance.  Lets workout an example which helped me understand it better:

Mahesh Borrowed Rs.100 from me (He can’t expect more then Rs.100 from me :() at 10%p.a. I doubt whether he will obey his obligation. So, I move to Dinesh who is ready to insure my credit but he is asking for some cash i.e.Rs.3 for the risk which now he is ready to take (Premium incase of insurance). I incur a cost of Rs.3 by insuring my credit (Interest Earned = 10-3 = 7). So If Mahesh defaults Dinesh will pay me the Balance. CDS is like a term plan for credit whether the borrower defaults or not one has to shell out premium as expense which is non-recoverable. So we understood one thing if Dinesh was to ask Rs.5 as premium then probably Dinesh is contemplating that chances or say probability of Mahesh defaulting is comparatively high.

Bonds are issued by Govt., Corporate, Local Bodies, Banks, Etc. Major countries precisely Govt.) CDS can be easily available for major securities. Now even Govt. bonds have CDS quoted to them by hedge funds, traders, etc which inturn dictates the value of the country.  If CDS of ABC country bond is higher then that signifies that the probability of default is high.

Link for Latest CDS Data but India not available 😦

SBI Bond CDS acts as proxy for the sovereign because the Our Govt. has never sold overseas debt. As on ~25Aug the CDS for SBI 5yr CDS was ~320bps (I read it in newspaper. If anyone can help me with the source?). When we compare with other countries India seems to be a bigger investment risk than emerging markets such as Vietnam and more than double the risk of fellow BRICS Brazil, Russia, China, and South Africa.

If you look at CDS data available on above link Denmark, Finland, Germany & US face low Credit Risk. Hence during tough times we observe flight to safety towards this Govt. Bonds. We can also observe that Greece CDS is excessively high (I don’t have any word which gives more stress effect then excessively). One thing to note here is Greece 5yr CDS is ~156% (as on 30/08/2012) and 5Yr G-sec (Click Here) is ~61% so CDS higher is then yield. So I think it means that to save your Principle Interest ($100+$61) one needs to insure by paying $156. Hence no one new except ECB will buy Greek bonds. If someone is holding it then he will probably insure it and get (161-156) 5$ from his investment. I Hope I am right.

So motto was to fit in a new parameter i.e. CDS bps into brain cells so as supplement research workings.

On this topic would like to hear from others as well with their findings.

More about Kush Sonigara on Google+

Tag Cloud