Friday, October 31, 2008

Systemic Risk in the Sovereign Air

Larger-than-life market-perceptions of systemic risk have blown sovereign debt wider and their credit default swap (CDS) levels to epic proportions.

With the US Treasury's 10-year CDS as wide as 40 bps (i.e., 0.4%) -- a 40-fold since early 2007 -- we're being forced to re-evaluate just what is meant by the "risk-free" rate of return (which is traditionally the UST, in fixed-income world).

According to the following chart (click on it to enlarge), perhaps 27 bps should be the minimum credit-related risk-adjustment used in conjunction with discounting by by the "new" risk free rate...
(1 basis point (bp) = 0.01%. In other words, the seller of protection earns a 0.4% annual premium on US debt, versus a 39.5% annual premium on Argentina; but beware that shorting the CDS will require you to post wicked amounts of margin given the volatility.)

Remember: A country's default probability is a measure of both its ability and its willingness to pay its debt.

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