Sunday, 2 November 2008

What do CDS spreads mean?

Naked capitalism suggests that some observers are perplexed by widening CDS spreads on US government debt.
How, they ask, could a private sector contract against default be expected to pay out in the case of a US government default – which would be the equivalent of a nuclear explosion in the financial markets?
The ten year Euro-settled spread has gone out considerably:All that is going on, of course, is that people are buying the contract because they think the spread will go out further. That will happen if more people buy it. More buyers than sellers equals rising prices. The actual default of the US has little to do with it for the buyers: they care about spread movements, and making money from them. Sellers are presumably happy to take what they view as an immaterial risk.

Update. Bloomberg has an article which confirms the idea that a lot of CDS trading is driven by speculation on the spread rather than insurance against default. They report that the most active contracts recently include those on Italy and Spain. Dubious though both countries' finances may be, default from either is vastly unlikely - but spread widening is rather likely.

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