What are Credit Default Swaps?

Since I am stuck in a snow storm in Michigan, I want to take this opportunity to republish an article that I posted on FX360.com earlier this week to explain Credit Default Swap Spreads – a term that is used often in the financial media these days:

What are Credit Default Swaps ?

A credit swap is like an insurance contract. The buyer of a credit default swap receives a payment if the underlying (company or country) defaults which basically means that he or she is buying insurance for a default. In return, the seller will require regular payments from the buyer. The best way to describe a 5 -year credit default swap is to compare it to a 5 year term life insurance contract. You make a payment at regular periods of time so that if the “credit event” or “death” occurs within 5 years, a lump sum is paid. If it does not happen, then the seller simply retains to payment and your “insurance” expires.

What are Credit Default Swap Spreads ?

Credit default swap spreads are the cost of the protection expressed as an annualized percent of the notional amount. So for example if the 5-year swap spread on Greek debt is 400 basis points it means that it costs 4 percent of the notional to protect against a default of Greek government debt within 5 years. On a $10 million bond, investors would require an annualized payment of $400,000 in this case to be willing to bear the risk of Greece defaulting on their bonds.

Why is this Important for Forex Traders ?

The spreads of credit default swaps are important because they measure how investors feel about the likelihood of a default and these days, the focus is on sovereign debt default. If the spread increases it means that investors believe the possibility of a default has risen as well. Since the value of a currency also reflects how investors feel about that country, it is natural for credit default spreads and currencies to move in the same direction especially when there is a serious risk of default. The following chart illustrates the relationship between the EUR/USD (white line) and the 5-year Credit Default Swap Spread for Greece (orange line). As you can see, they have a very strong correlation because the fear of a Greek default has encouraged investors to pull money out of the Eurozone. The chart also shows that the Orange Line (Greek CDS) has been leading the White Line (EUR/USD) over the past few months which means that for the EUR/USD to recover, Greek CDS spreads need to stop falling and start stabilizing.

How Does the Risk of Investing in Greece Compare to the Rest of the World ?

Greek 5 year CDS spreads are approximately 400bp. To compare that with the rest of the world, the 5-year spread for the U.S. and Germany are approximately 35bp. The spread for Canada is in the area of 15bp. For France it is 60bp and for Japan and the U.K., who have recently received warnings from ratings agencies about possible downgrade have, their CDS spreads are approximately 90bp. These are substantially less than Greece’s credit default spreads but of course that reflects the risk of investing in a nation that could be at the brink of bankruptcy.

There are no market moving U.S. economic data on the calendar tomorrow which means that sovereign debt risk and CDS spreads will continue to be one of the primary drivers of currencies. We hope that you now have a bit more understanding of CDS spreads which are mentioned on a daily basis these days. Feel free to post questions if you need further clarification.

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