June 19, 2012

Credit Default Swaps Spreads for European Debt

The Credit Default Swaps spreads for European debt.

5-Year CDS Spreads on Eurozone Credit Default Swaps

St Louis Fed has a good overview of the role of Credit Default Swaps (CDS) in the ongoing European debt crisis. 
Therefore, buying a CDS can be analogous to an individual insuring his neighbor's car and getting paid if the neighbor is involved in a car accident. Just like in an insurance contract, the individual pays a periodic premium to a CDS seller in return for compensation should the credit event (accident) occur. Importantly, the individual is compensated even though he may have no financial stake in his neighbor's car.

Unlike with insurance arrangements, sellers of CDS were not subject to significant regulation and were not required to hold reserves against CDS in case of default. It is widely believed that this exacerbated the recent financial crisis by allowing financial firms to sell insurance on various securities backed by residential mortgages and other assets.

Typically, the CDS requires that the purchaser pay a spread (fee) quoted in percentage (basis points) of the amount insured. For example, the protection buyer of a CDS contract of an insured amount of $20 million and a premium of 100 basis points pays a (quarterly) premium of $50,000 to the CDS seller. The premiums continue until the contract expires or the credit event occurs. Higher premiums indicate a greater likelihood of the credit event.

The distressed-Eurozone CDS spreads start rising after 2008 (as shown in the chart above).

Tags: credit default swaps, european debt CDS, 5-year CDS spreads eurozone, st louis fed