Hedges, Credit Default Swaps and the Euro Area - would you credit it?

About this time very year, as the clocks go back, I ask my students: How do I hedge risk?  Eventually we stumble on the answer which involves buying an asset whose prices changes, or returns in financial language, are negatively correlated with those of my current portfolio.  Thus I give up a little of the returns from my current portfolio and add an asset whose returns will be high (low) when those of my current portfolio will be low (high).  And so I ensure, through the purchase (giving up of some of returns) of a hedge, that my returns or income stream is better stabilised.   The hedge will not make you rich and “will not make you look five pounds thinner” but will be preferred by anyone who wishes to stabilise returns from their portfolio over a larger range of possible events.  The price that people are willing to pay for hedges can give us very useful information on the market’s perception of risk.

Let us, for example, consider credit default swaps on sovereign debt.  These instruments are simply instrument designed to make a risky government bond into a risk-free government bond (you can buy them on corporates but let's concentrate on govvies).  The holder of a risky bond buys a hedge from someone who wishes to sell insurance.  The seller of the credit default swap (CDS) collects the premia from the owner of the risky bond and insures against default by promising to pay the par value of the bond in the event of a default, or “credit event” by the original debt issuer.  In the event of no default, the seller of the CDS simply collects premia and the owner of the bond has reduces his stream of payoffs by the amount of the insurance paid.  The returns from the risky bonds are thus shared between the owner and the seller of the CDS and in principle the combination of holding a risky bond plus a CDS “insurance” contract recovers a risk-free bond for the bond holder.  The seller of the CDS is just collecting insurance premia, having calculated that the expected value of these premia are no less than the cost of par value of the bonds insured times the probability of default. 

The buyer of the CDS pays a percentage of their notional principal and this is called the CDS spread and given reasonably ordered markets are indicative of the riskiness of a given sovereign’s (or corporate's) debt.  There are a number of caveats attached to reading the spreads as indicating risk directly: (i) liquidity in CDS markets, there are over the counter may not always be high, which means spreads may reflect time-varying liquidity premia; (ii) insurance premia may include fixed cost, which drives the spread up; (iii) they reflect risk aversion rather that credit risk, per se, and, relatedly (iv) may reflect a more general contagion rather than an individual country or sovereign risk.  And so we have to be very careful in interpreting the level of spreads and their changes.  

But for the sake of telling a story, let us now look at this CDS spreads for 10 year protection for a group of advanced economies in and outside the Euro Area.  The actual spreads suggest that Spain and Italy lie outside the norm, with spreads at around 300bp.  But if we simply re-index the series for January 2010, which is rather arbitrary admittedly, but we might use a start date of sorts for the Euro-crisis – it is the date that the EU cast doubts on theGreek deficit numbers – we can observe a bifurcation of sorts between the change in the spread between 2010 and today for the EMU countries and non-EMU countries.  The latter have been relatively flat, implying the financial market price have not priced in especially higher rates of Soveriegn risk, even though sustained economic growth has not returned. But for the four Euro Area economies Italy, France, Germany and Spain, CDS spreads seemed to have, at least, tripled.  Whether this is contagion or liquidity or a true measure of heightened Euro Area risk, I leave for another time.  But the price of a hedge does seem to say something clear cut about the continuing problems of the Euro Area and that much work remains to be done.