US Government Debt Different - Finance Department - University of ...

76 A Market for End-of-the-World Insurance? Credit Default Swaps on US Government DebtFigure 1: Greek Sovereign Debt CDS Prices (in bps)Source: BloombergThe actual percentage payout when the CDS on Greek sovereigndebt were triggered was, as noted above, 78.5%. Using this figure,the CDS market price on April 1, 2011, implies a probability of defaultwithin the next year of 12.0%. 17 Given that actual default wasless than one year away, this implied probability is surprisingly low,raising questions about the accuracy of CDS prices as default predictors,except perhaps in the very short term. (As Figure 1 indicates,prices did begin a rapid ascent in the summer of 2011. 18 ) Althoughone possible explanation for this seemingly low probability is thatinvestors underestimated the payout percentage, a more modest payoutpercentage of 40% raises the implied annual default probability17 The implied default probability is calculated here as the probability that causesthe expected present value of the premium payments over five years to equal thepresent value of the expected payout if the reference debt defaults. A higher defaultprobability increases the expected payout value, and it also decreases the expectedpremium payments given that no payments are made after a payout occurs.For a formal derivation of this formula, see Deutsche Bank Research,Sovereign default probabilities online – Extracting implied default probabilities fromCDS spreads, http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000183612.PDF. The figures presented here were calculated usingUS Treasury yields for the time value of money. See U.S. Dep’t of the Treasury,http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualization.aspx. As noted in the text, the risk premium is ignored,as is counterparty default risk, the implications of which are discussed below.18 On October 3, 2011, the price had risen to 5273.0 basis points, which assumingthe actual payout percentage of 78.5% implies a default probability of 52.1%within one year.