Pricing the risk of Ireland Inc defaulting

BenjAii

As I don't know myself, I'd be really interested to hear the views of those with direct experience in this market, as to how this pricing is arrived at.

http://www.reuters.com/article/bondsNews/idUSL262883620081202

The cost of credit default swaps (which prices the risk investors see in the government defaulting) has increased 7 fold for Ireland since mid-September.

This is priced at 66.4 basis points for the US, 106.4 for the UK, 161.5 for Italy, and 213.4 for Ireland, putting as at almost the top of this particular European league table.

I'm guessing there is not a set model behind this and it all comes about because of perception.

In which case, how is this so? How are these judgments made ? How do market participants arrive at the conclusion Ireland is far more likely to default, given that (as far as i'm aware) it hasn't before ?

nesf

BenjAii wrote: »

How do market participants arrive at the conclusion Ireland is far more likely to default, given that (as far as i'm aware) it hasn't before ?

Well, two points on this. Our chance of defaulting started from a very low base so the increase sounds a lot bigger than it really is. The second is that the bank guarantee provides an unlikely but possible way for forcing the Government to default on its loans and this will naturally raise the spread.

Mikel

Deficits, Debt to GDP ratio, that kind of thing.
Add in the guarantee scheme, which in theory is greater than the GDP of the country (or GNP, I forget which) and the perceived risk is higher, hence the spread is greater

babytooth

Lots of things influence it, such as supply and demand, similar bonds vs benchmarks, peoples exsposure, related exsposure etc....

not an exact science but arbitrage can drive the spread to be equal across same bond....

won't bore you with details unless u want them...

Mikel

I don't watch these closely, but Germany at 52 and US 66?
I know the world has gone mad but even still that makes no sense.

Interesting you mention arbitrage, it would be a brave man nowadays who was sure his position was an arb. You'd need to be a lawyer rather than a trader

BenjAii

Thanks for that babytooth.

I'm a little confused, I thought it was directly related to the perception of default risk, though obviously that could be for myriad reasons.

I'd assumed the bank guarantees would feature, just wondering what more there was to it.

Mikel

The perception of default would be the biggest factor, but there are always market structure factors which influence things.

Personally I think the CDS on the US at 66 is insane.
By definition the US is risk free, that's free money imo

babytooth

Mikel wrote: »

The perception of default would be the biggest factor, but there are always market structure factors which influence things.

Personally I think the CDS on the US at 66 is insane.
By definition the US is risk free, that's free money imo

its not risk free, there's no such thing.....what about fx risk, devaluation risk, default risk and so...i agree its somewhat hard but no one wants to trade at the moment hence the higher premium

abitlonely

Who would find safety in thinking an investment bank will save the day for you when the US / Germany default?

Has anyone ever heard of a CDS on a CDS yet?

BenjAii

abitlonely wrote: »

Who would find safety in thinking an investment bank will save the day for you when the US / Germany default?

Has anyone ever heard of a CDS on a CDS yet?

I have to admit I still don't understand how conclusions are arrived at in varying perceptions of different countries default risks, when pricing CDS.
Especially how fx or devaluation risk could come into it when comparing Eurozone countries, which surely share that risk equally.

One thing I find curious is Germany's position as the European benchmark.

It certainly leads the league tables on European countries with a history of political and financial instability, though of course the days of WW1, Weimar Republic, and WW2 long behind it.

Économiste Monétaire

As it was already said, the perception of risk vis-a-vis Germany can help you with a reason why it is the benchmark. Germany is the largest economy in Europe, and currently has a balanced (or marginal surplus) budget. We have a guarantee of about 450 billion on the liabilities of banks (that value is over twice our GDP), we are financing a current deficit, and because we're a small and open an economy we're more susceptible to the downturn. All that would add to the perception of risk, in my opinion. Babytooth and Mikel listed some more. Just consider the idea of either country, Ireland or Germany, defaulting on its debt--which of the two is relatively more likely...

(I'm under no illusion that the actual models used to price CDS are far more complicated than I'm saying here :pac:)

babytooth

CDS are alot of the times priced relative to other CDS.

So, for example, if germany is at 50 bps for a 5yr CDS, and the Itialian bonds are trading at 100 bps over the benchmark Bund ( german bond) then, generally, the CDS for Italy will be trading at 150 bps. What you will find is that the CDS will trade at a higher level to the German CDS relative to the 2 countires bonds. This is, because, at the moment, investors want to cover positions so the CDS is in demand. And as the CDS is cheaper, due to no up front funding costs, then the CDS will trade with a liquidty premium to the differential between the two bonds...

Although this is a simplified version, this is pretty much what happens. Traders watch the flow of trades and will adjust prices if they see the open cover decreasing and vice versa....

Mikel

babytooth wrote: »

its not risk free, there's no such thing.....what about fx risk, devaluation risk, default risk and so...i agree its somewhat hard but no one wants to trade at the moment hence the higher premium

Well it is risk free by definition, and then everything else is priced against that.
The notion of introducing the risk of the US Gov defaulting and charging a price for it is really nonsense.
If you've bought a CDS on US Treasuries and they default, where are you going to go to claim your payout? There won't be any banks left, at that point we can all pack up and go home.
So selling that particular CDS to me is free money.

I can only imagine the reason for it's existence is that funds which hold Treasuries have been told to buy the CDS to 'reduce their risk' when in actual fact they've probably increased it

daveirl

This post has been deleted.

babytooth

Mikel wrote: »

Well it is risk free by definition, and then everything else is priced against that.
The notion of introducing the risk of the US Gov defaulting and charging a price for it is really nonsense.
If you've bought a CDS on US Treasuries and they default, where are you going to go to claim your payout? There won't be any banks left, at that point we can all pack up and go home.
So selling that particular CDS to me is free money.

I can only imagine the reason for it's existence is that funds which hold Treasuries have been told to buy the CDS to 'reduce their risk' when in actual fact they've probably increased it

its not risk free......i can see your point, its consdiered risk free, well the nearest thing to it but it is still not risk free.

There is always a risk.
Can the US default, why yes, of course they can, and the IMF and the world bank would step in...Debt would be restrucutred...Is this likely, No. Even remotely, no!.


CDS don't just cover a "hard" default, but various things like technical default, certain restrucutings and several other factors, and these too influence the spreads....as does the assumed recovery rate.

Check out the ISDA defs 2001 for CDS info. and also my link on the Economics Resource thread for articles explaining alot of the interplay going on.

But to repear, the US Tbill is taken as the closet proxy for the risk free rate, which is now negative, so can we assume that there then no risk free rate....hmmmmm....

I think Germany is a better proxy...but thats just me...

Mikel

babytooth wrote: »

its not risk free......i can see your point, its consdiered risk free, well the nearest thing to it but it is still not risk free.

There is always a risk.
Can the US default, why yes, of course they can, and the IMF and the world bank would step in...Debt would be restrucutred...Is this likely, No. Even remotely, no!.

CDS don't just cover a "hard" default, but various things like technical default, certain restrucutings and several other factors, and these too influence the spreads....as does the assumed recovery rate.

Check out the ISDA defs 2001 for CDS info. and also my link on the Economics Resource thread for articles explaining alot of the interplay going on.

But to repear, the US Tbill is taken as the closet proxy for the risk free rate, which is now negative, so can we assume that there then no risk free rate....hmmmmm....

Nope the US can't default. I don't mean that it's very unlikely, I mean there is no mechanism in place to cater for that eventuality. The consequences are basically unimaginable, IMF and World Bank?? Who funds them? If the US can't borrow than neither can any other Gov.
The entire financial system is built on the notion it can't happen.

DaveIrl wrote:

I'll write insurance at 10bps for US debt if anyone wants to buy it, just try prising me out of my cave if the US defaults and I have to pay it.

Exactly.

Maybe it doesn't trade at all and someone was over a barrel to transact and a quote was plucked out of the sky

BenjAii

Interesting commentary from Martin Wolf in the FT on Ireland and some other Eurozone countries perceived decrease in credit worthiness.

http://www.ft.com/cms/s/0/ce9378ce-c624-11dd-a741-000077b07658.html

Mikel - surely the fact that the market is pricing a risk of a US default, means you in a minority thinking it's impossible ?

It doesn't matter that the consequences don't bear thinking about, or that there is no IMF or World Bank to rescue it, or that is extremely unlikely. There is obviously some risk, as perceived by the market, or this price wouldn't exist ?

And while it's improbable it's not hard to imagine scenarios where it could happen that the US could not refinance it's debt. China invading Taiwan, or Israel attacking Iran could conceivably set in motion a chain of events where this could occur.

Mikel

BenjAii wrote: »

Interesting commentary from Martin Wolf in the FT on Ireland and some other Eurozone countries perceived decrease in credit worthiness.

http://www.ft.com/cms/s/0/ce9378ce-c624-11dd-a741-000077b07658.html

Mikel - surely the fact that the market is pricing a risk of a US default, means you in a minority thinking it's impossible ?
It doesn't matter that the consequences don't bear thinking about, or that there is no IMF or World Bank to rescue it, or that is extremely unlikely. There is obviously some risk, as perceived by the market, or this price wouldn't exist ?
And while it's improbable it's not hard to imagine scenarios where it could happen that the US could not refinance it's debt. China invading Taiwan, or Israel attacking Iran could conceivably set in motion a chain of events where this could occur.

I seem to be in a minority if the spread really trades, but if it does it's free money imo.
You see, if it did happen, the system collapses, there is nowhere to claim the payoff from, do you get what I mean?
It's pointless to buy it, if the US goes bust everyone goes bust.
There will be no financial system, capitalism has failed and like dave says we'll be living in caves.

silverharp

Mikel wrote: »

I seem to be in a minority if the spread really trades, but if it does it's free money imo.
You see, if it did happen, the system collapses, there is nowhere to claim the payoff from, do you get what I mean?
It's pointless to buy it, if the US goes bust everyone goes bust.
There will be no financial system, capitalism has failed and like dave says we'll be living in caves.

You would have to define the US going bust. US debt is denominated in dollars so the US will not default on its bonds, the obvious risk is currency devauluation and the bond holders taking losses in terms on purchasing power

Mikel

The currency devaluing is not a default, a default is when they renege on their debt

BenjAii

Having looked around a bit it appears those spreads aren't all about default risk anyway ......

http://www.portfolio.com/views/blogs/market-movers/2008/12/09/in-defense-of-the-cds-market

"Kai Gilkes of CreditSights, who confirmed for me that it's pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it's impossible to isolate expected default probabilities. ........... since right now CDS spreads tell us precisely nothing about expected default rates."

And on a tangent, from April 2008

Mortgage Insurers (Quietly) Downgraded: CDS Spreads Scream Trouble

Who said no one saw things coming ...