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Default risk vs. Spread risk

By Anonymous

Paul Krugman comments on the rising CDS spreads on US government debt:

Has the risk of a US government default risen? Probably. Nonetheless, the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?

Oh my god, repeat after me: CDS on U.S. government debt are spread products. Protection buyers aren't hedging default risk, they're hedging spread risk. For example, a bank that has a large inventory of Treasuries will want to hedge the risk of a significant deterioration in the value of Treasuries. Since standard CDS provide for daily collateral posting based on the value of the underlying reference obligation(s), protection sellers in CDS on U.S. government debt have to post more collateral when the value of Treasuries declines.

Default risk vs. spread risk isn't a difficult or terribly advanced concept, and it's definitely something you should know if you consider yourself to be an "informed commentator" on the bank rescue.

Full post as published by Economics of Contempt on March 11, 2009 (boomark / email).