Creditflux Newsletter

So a country name is full up and the firm hedges it by buying protection - but in doing so goes long counterparty credit risk with another name? how do we hedge that?...this is how we end up w banks which are too big to fail all over again

The immediately preceding post is exactly right that CDS spreads (sovereign or otherwise) are "fully loaded" for default risk. So, right on, it's not that complicated. Further, the US government will CERTAINLY default on some obligations (though possibly not direct debt in the near term). Can I add my future social security payments as an Obligation to a CDS contract?

All good points - thanks for the debate. The genesis of the letter was irritation: just as the media all too often refers to "toxic products such as credit derivatives", it also states that CDS spreads are only a measure of default and have a major impact on cost of borrowing. We wanted to broaden understanding though right now it wouldn't help if attention shifted to the high degree of speculation referred to below!

Of course no one "thinks" the UK will default, but these are just way out of the money options. If the chance of a default happening goes from 1% to 2%, the spread goes up. It's not really that complicated. This whole country limits arguement is just the same silliness that the main users of corporate CDS are those insuring their bond positions. 99% of the CDS market are speculators -- same as the FX market. That's how you have deep liquid markets...

The sovereign cds spread (at least for the G8) is only to a small part driven by rewards for actual default risk. They are absolutely right. The probably biggest component to the sovereign cds spreads is liquidity risk

Sounds like a "greater fool" theory of trading. I know the UK and the US are not going to default so I am willing to pay money to protect against this risk (which I don't believe is a risk) on the expectation that someone who is a "greater fool" than I am and will pay even more than me to protect against the risk in the future. Perhaps the "greater fools" reside in the risk departments of these banks who set country limits on the Uk and the US in the first place ?

OK.. are we talking about Jump-to-default probabilities here..? I do recognize that CDS and cash Bonds of the same credit are not necessary the same risk as the trading characteristics are different, but pretty close. Therefore I am not entirely sure if these guys are right, though I enormous respect for them...

Mmmmm.... no one in their right mind thought that Lehman Brothers or Bear Stearns were going to disappear...