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

72 A Market for End-of-the-World Insurance? Credit Default Swaps on US Government Debtfunction does not apply to CDS on high-grade government debtsuch as that of the US and Germany.• Investment-risk hedging: Some observers have argued that investorsmay be able to create a position that mimics the safety ofUS debt but provides higher returns by purchasing high-yield,emerging-country sovereign debt and then covering it with CDSfrom a low-risk protection seller. 6 Once again, this function doesnot apply to CDS on low-yield government debt such as that ofthe US.• “Pure play” default speculation: CDS permits investors to focustheir exposure, separating default risk from other factors thataffect bond yields, such as prepayment risk and—especially ifthe CDS and the reference debt are denominated in differentcurrencies, as is often the case—inflation risk.In addition to these more conventional explanations for demand forgovernment-debt CDS, there is a fourth potential explanation thatbank regulators should keep in mind:• Exploitation of opportunism-induced underpricing: If a CDS protectionseller’s managers are motivated to maximize shareholderprofits, and they believe that the risk that liability on the CDSwill be triggered is highly correlated with their firm’s insolvencyrisk, then they face an incentive to increase CDS sales by cuttingthe price charged to protection buyers below the expected liabilityon the contracts. This incentive arises because most of theexpected liability on such contracts is borne by the firm’s generalcreditors rather than by its shareholders. Protection buyers willthen be able to profit through the difference between prices andexpected payouts.Besides these private functions of CDS on government debt, suchcontracts can provide a public benefit. An important component ofthe market price of a CDS contract is an estimate of the likelihood6 Id. Why arbitrage would not eliminate the profitability of such positions is unclear.