What with the PIGS (Portugal, Ireland/Italy, Greece, Spain)–not my creation, that acronym–in the news of late (all are on the brink of serious economic problems), I thought it appropriate to look at the Credit Default Swap pricing of sovereign debt.
A credit default swap (CDS) is a derivative instrument purchased to protect against default by a borrower. CDS are priced in terms of basis points (0.01%) per notional value of debt.
Notional value is a term used with derivatives to describe the value of the underlying asset, since derivatives are derived from an underlying asset. A buyer or seller of credit default swaps isn’t required to own the underlying asset, so notional value becomes crucial.
As an example, the cost to insure U.S. debt for five years (5-year CDS) is 41.6 basis points, or 0.416%, per year. So the buyer of the CDS on $1 million of debt would pay the seller $4,160 per year for five years. In contrast, a CDS buyer on $1 million of Ukraine debt would pay 1,242 basis points (12.42%), or $124,200, for five years.
Those are the numbers that underlie the chart below, which I’ve modified to reflect the default likelihood relative to the U.S, which each gridline representing a multiple of one. For example, South Korea reaches just past the second gridline, so it’s just a bit more than two times as likely to default as the U.S.; Peru, three times; Ukraine, 30 times, and so forth.