Introduction

In many sessions, I introduce the notion of a “risk-free asset”.  When I bring up the US Treasury Bill, I expect a lot of eyes to roll.  After all, Standard and Poor’s downgraded the US debt from AAA to AA+ back in August 2011.  While that may be, when looking at CDS prices, it seems that investors still perceive the US Treasury to be pretty risk free.

Credit Default Swaps (CDS)
A quick aside on CDSs for those who are new to them. A Credit Default Swap is a swap of default risk [;-)]. It is simply an insurance policy that will cover any losses on debt, should the issuer default. Since I like to think of them as insurance, let’s use an analogy.

Say that you are an insurance company and that you currently provide earthquake coverage for the Transamerica Building in San Francisco. After inspecting your book of business, you notice that you seem to be providing earthquake coverage to a lot properties in San Francisco. Should an earthquake hit the area, the losses could be staggering, as these are pretty correlated risks. In insurance, a well-established reinsurance market exists to take over part, or all, of this risk off of your books. For a premium, you can swap the risk to a reinsurance company.

The same basic principle applies to insuring bonds with a CDS. For an annual premium, usually quoted in beeps of the notional value (or insurance amount), default risk can be swapped to another company. (*)

Investor Perception of US Default Risk
The below Bloomberg Chart offers the most recent 5-year US CDS prices. In other words, this provide the costs of insuring against US default for the next 5 years.

Source: Bloomberg.com

A few things to note:

  1. As of 05/08/2012, doing so currently costs 41 beeps (per year), which is an annual premium of $41 for every $10,000 of notional.
  2. These are only 5-year prices, probably shorter in term than S&P’s mindset for its rating.  This means that we cannot make too direct of a comparison between the rating and CDS prices.  That being said, five years is longer in term than the theoretical notion of a risk-free rate (usually one year).
  3. The price was in the teens prior to July 2009, showing that investors do believe that the US debt is slightly riskier now than it once was.
  4. The current price is not all that different from what it has been in the last few years, with no apparent spike following the downgrade.

So what?  Is that high, or low?  Here is a list of Sovereign CDS Prices (as of 05/08/2012).  Current prices can be obtained here (CNBC).

Source CNBC.com

A few things to note:

  1. The US CDS is the lowest on this list.
  2. The list is not complete.  Out of the 14-AAA rated countries, only 7 are on this list: Denmark, Finland, Germany, Netherlands, Sweden, Switzerland, and United Kingdom.

Summary

The US downgrade notwithstanding, it seems that investors still believe the US Treasury to be the world’s risk free asset (though not quite risk free).


Category: CAIA, CFA, CIMA

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