CDS explained part 2. Why are they important to us??

The main goal of credit default markets is to establish market prices for a given default risk. As in all other markets, the market price of a CDS is established based on on the law of supply and demand.

The credit default swap market plays a huge role in financial speculation nowadays. Depending on how risky (depending on the possibility of bankrupcy or possibility of default on debt) investors percieve a sovereign to be, they will decide if they want to bet in its favour, insuring its solvency, i.e. sell protection on a CDS (and thus recieving premiums)  or bet against it, buying protection, thus paying the periodical premium (because they expect a credit event to happen, which mean that they would recieved the notional amount specified on the contract (usually $10million).

The rate of payments made per year by the buyer is known as the CDS spread. If there are more buyers than sellers in the market, the spread widens, meaning that it will cost more to buy protection on that particular CDS. 100 basis points equal a 1% interest.

Now lets look at what are known as the CDS market "hot charts" on sovereign debt:

These charts above have been the source of all these rumours we have been hearing from friends, we have been reading on facebook, twitter, and now even in the news! (meaning its now no more a taboo to talk about it!) about a possibility of a collapse of the eurozone.



Did he just say it? Yes- I said it. What these charts mean is that more and more speculators are buying protection on these sovereigns and less are selling it- meaning that more people are expecting a credit event to occur. For example right now someone buying protection on italy has to pay 5.5% interest per year on the notional amount of a contract to the seller of insurance. If, for example, the notional amount of a contract is $10million, the buyer will have to pay $550000 per annum to the seller in interests until maturity. Should the pre-specified credit event occur, however, the seller of protection deliveres to the buyer of the CDS the notional amount of the contract, $10million in exchange.

The reason why the credit default swap market is so important to international investors and expecially to sovereigns is because of the very high correlation that credit defaults swap spreads have with sovereign bond yields. Just look at these charts:

It is apparent even to the eye of someone who knows nothing about finance and economics that CDS on and bonds issued by the same sovereign follow very much the same trend, with moves in the CDS market often actually anticipating moves in the bond market. (Palladini G., Portes R., 2011)

Therefore investors holding sovereign bonds issued by troubled economies (such as the piigs) or speculators willing to enter this high-risk (but also with high profit potential) trade should always keep an eye on the CDS markets, to try to anticipate market moves and be able to act on their credit risk exposure to these economies.