Unexpectedly Intriguing!
May 24, 2011
Climbing a Wall of Worry - Source: Fidelity

How likely is it that a country will default on part or all of its national debt in the next five years?

That's a question that we can use the reported spreads in Credit Default Swaps (CDS) for debt issued by sovereign nations to answer!

Since credit default swaps are a kind of insurance policy that only pays out if a borrower defaults against the owner of the debt, the cost of these financial instruments will depend greatly upon the likelihood of a default occurring.

That question is immediately relevant for nations like Greece and Venezuela, both of which are above the critical 50% threshold for five-year CDS spreads, suggesting that both are very likely to default on their government's debt within the next five years.

Unfortunately, that question also applies to a number of other nations that are going through severe financial crises that are pushing them up the a debt-driven "wall of worry". But how can we use the CDS spread data that we can find on the web to estimate what the odds are that the country in question will go into default?

We've sampled CDS spread data from CMA DataVision on 21 May 2011, which we used to reverse engineer a formula to estimate the cumulative probability that a nation will default on its government-issued debt within the next five years, which we've presented in the chart below:

Cumulative Probability of Default Within Five Years for Sovereign Nations Based Upon Credit Default Swap Mid-Spread Values on 21 May 2011

We next built a tool using the relationship we found so that you can estimate a country's likelihood of defaulting upon its national debt if you only know the mid-spread value of the Credit Default Swaps for the next five-year period that have been issued against it.

Credit Default Swap Data
Input Data Values
Five-Year Credit Default Swap Mid-Spread Value


Estimated Cumulative Probability of Default
Calculated Results Values
Probability that Nation Will Default

Some quick notes. First, since we sampled the data to create our default probability model on 21 May 2011, our tool's results are best considered as being in reference to the world's financial situation on that date.

Second, the value of CDS spreads don't just take a nation's default likelihood into account. Vincent Ryan at CFO.com reports that CDS' can also reflect considerations such as "market liquidity, counterparty risks, and technical factors, such as the high leverage inherent in swaps that apply to the CDS itself", which means that just a straight reading of the value may overstate the probability of default to some extent.

Third, and finally, we only had the data going up as far as Greece, which makes the portion of our model that projects beyond the default probability for that nation potentially less accurate than the portions of the CDS values for which we do have data.

The way we figure it though is that if we're talking about a nation that's in a worse situation than Greece on 21 May 2011, the accuracy of the calculation of the nation's probability of default is perhaps the last thing with which people should be concerned. You're more than likely well past the point of "if" and should instead be considering "when."

Image Credit: Fidelity

Labels: , ,

About Political Calculations



blog advertising
is good for you

Welcome to the blogosphere's toolchest! Here, unlike other blogs dedicated to analyzing current events, we create easy-to-use, simple tools to do the math related to them so you can get in on the action too! If you would like to learn more about these tools, or if you would like to contribute ideas to develop for this blog, please e-mail us at:

ironman at politicalcalculations.com

Thanks in advance!

Recent Posts

Applications

This year, we'll be experimenting with a number of apps to bring more of a current events focus to Political Calculations - we're test driving the app(s) below!

Most Popular Posts
Quick Index

Site Data

This site is primarily powered by:

This page is powered by Blogger. Isn't yours?

Visitors since December 6, 2004:

CSS Validation

Valid CSS!

RSS Site Feed

AddThis Feed Button

JavaScript

The tools on this site are built using JavaScript. If you would like to learn more, one of the best free resources on the web is available at W3Schools.com.

Other Cool Resources

Blog Roll

Market Links
Charities We Support
Recommended Reading
Recommended Viewing
Recently Shopped

Seeking Alpha Certified

Archives
Legal Disclaimer

Materials on this website are published by Political Calculations to provide visitors with free information and insights regarding the incentives created by the laws and policies described. However, this website is not designed for the purpose of providing legal, medical or financial advice to individuals. Visitors should not rely upon information on this website as a substitute for personal legal, medical or financial advice. While we make every effort to provide accurate website information, laws can change and inaccuracies happen despite our best efforts. If you have an individual problem, you should seek advice from a licensed professional in your state, i.e., by a competent authority with specialized knowledge who can apply it to the particular circumstances of your case.