Of course it’s not theoretically 0. In reality it should be 0, but it’s not. Note that it should be 0 not because the US Gov’t can’t default, but that no trading counterparty would exist to pay if you off in the event of default. However, the instruments exists to play the relative changes in treasury pricing.
Deleted User
Me. If they’ve gone up 25x in one year.
Deleted User
I’ve suggested to my boss that this would be the ultimate hedge on your equity portfolio as equity will only take a huge loss should there be doubt in the system as a whole.
NakedPuts Wrote:
——————————————————-
> Of course it’s not theoretically 0. In reality it
> should be 0, but it’s not. Note that it should be
> 0 not because the US Gov’t can’t default, but that
> no trading counterparty would exist to pay if you
> off in the event of default. However, the
> instruments exists to play the relative changes in
> treasury pricing.
i agree.
i wish i could put up 0 collateral, and sell $50MM and pocket $200K per year for 5 years… if UST defaults, i do too.
Deleted User
Well thats what I meant.. the spread increased 25x…
hmmm.. I wonder if we could lever ourselves up huge on these so that you can capture that 25x.. buy and sell options on these…
Deleted User
Who would pay for these to cover their Treasury debt if it doesn’t actually protect from default? I mean, people have to be buying these for the spread to widen…
MattLikesAnalysis Wrote:
——————————————————-
> Who would pay for these to cover their Treasury
> debt if it doesn’t actually protect from default?
> I mean, people have to be buying these for the
> spread to widen…
why not just sell 5 year UST futures? you can leverage there.
Deleted User
If Rome can fall so can the US and the economic/political world didn’t disappear from Rome’s “default”.
It is the global marketplace and there could still be wealth in a bankrupt country should the rules of private property remain in place and the monetary system is not completely inflated to the point where default is prevented but currency is destroyed.
If the government defaults, I think that we have many more problems to worry about. The money you would make on the default swap would probably be nearly worthless anyway.
JustPass Wrote:
——————————————————-
> Who would buy these?
Someone who thinks that the counterparty will pay up when the US Government can’t. I guess the counterparty must be North Korea, who makes the world’s best $100 bills.
I hadn’t thought about buying to capture spread changes. That seems quite risky to me because underlying default is probably highly correlated to conterparty default.
You want a quote? Haven’t I written enough already???
Deleted User
ConvertArb Wrote:
——————————————————-
> MattLikesAnalysis Wrote:
> ————————————————–
> —–
> > Me. If they’ve gone up 25x in one year.
>
>
> the spread has widen but you would not have made
> that much. maybe 1% (without modelling) if you
> bought these.
Would you really only get a 1% return should the spread move up by 25x? Whats the calculation here?
Deleted User
bchadwick Wrote:
——————————————————-
> JustPass Wrote:
> ————————————————–
> —–
> > Who would buy these?
>
> Someone who thinks that the counterparty will pay
> up when the US Government can’t. I guess the
> counterparty must be North Korea, who makes the
> world’s best $100 bills.
>
>
> I hadn’t thought about buying to capture spread
> changes. That seems quite risky to me because
> underlying default is probably highly correlated
> to conterparty default.
Maybe the bet isn’t about waiting until default, but waiting until the market prices most of the default in… Is it possible to have a public sector default and a running private sector? hehe. government bailout by corporations… mmm, facsism.
You could buy a CDS on your counterparty as well..?
MattLikesAnalysis Wrote:
——————————————————-
> Where can I find pricing for these?
Try CMA, a subsidiary of CME Group, which has a product called Quote Vision - it’s a price discovery service that takes all the thousands of emails a trader receives and creates a dashboard of prices. Not sure if they cover US Treasuries, but based on how their technology works, I don’t see why not.
Quote Vision - buy side
Data Vision - risk management/research
MattLikesAnalysis Wrote:
——————————————————-
> ConvertArb Wrote:
> ————————————————–
> —–
> > MattLikesAnalysis Wrote:
> >
> ————————————————–
>
> > —–
> > > Me. If they’ve gone up 25x in one year.
> >
> >
> > the spread has widen but you would not have
> made
> > that much. maybe 1% (without modelling) if you
> > bought these.
>
> Would you really only get a 1% return should the
> spread move up by 25x? Whats the calculation here?
you have to make some kind of assumptions here. let’s assume 40% recovery. I will model these out from 5 to 35bps.
At 5bps, an equlivent bond priced off the swap curve would be 99.76 using JP Morgan Model.
At 35bps, an equlivent bond priced off the swap curve would be 98.35
move of about 1.5 pts.
Deleted User
I’m thinking of this from a different POV.
Taking the actual prices of the spread from the link given above and being conservative (the move was a 25x increase, so lets assume 2bps and 44 bps for whole number sake)
So at 2bps.
You would have to pay $0.02 for every $100 of protection annually or $0.20 over a 10 years contract. Assuming the spread in the CDS dictates the probability of default, then the expected return in event of default is 0.002 x $60 (recovery rate) - $0.20 (cost of contract over its life) which equals -$0.08. So at this point there is a premium for the purchase of the contract due to the recovery rate assumption.
At the new price of 44bps:
You would have to pay $0.44 for every $100 of protection annully or $4.40 over the life of the contract. The expected return paying the $0.02/yr would be 0.044 x $60 - $0.20 equalling $2.44.
Wouldn’t the increase be approximately 25x as the probablility of default has come up and you have no investment except for the payments on the swap? The value of the $0.02/yr swap is now much higher as an equivalent swap now costs $0.44/yr.
Mind you, these probabilities are very primative yet there is some conservative calculation as this assumes all payments are made, although payments would stop when default occurs.
actually it is the case but the math after that is what i have trouble with… the spread is the market, using the market you can then get a default probability, at a 5bps spread i get the arb free probability of 0.43% over the 5 year contract using 40% recovery.
Deleted User
Why would someone pay 25x more for something if the probability hasn’t increased dramatically?
The only idea about the probability of UST default is through what people will pay to protect against it.
Deleted User
Where are you getting your probabilities?
and if you can, can you calculate one for a 125 bps spread to compare to the 5bps spread?
Okay, so is it correct to say then that if you are calculating the risk free rate you should be using the treasury rate minus the CDS spread?
I used to smoke pot and go to class.
Sneak in ten minutes late with a bullsh*t excuse.
Slink down low at my desk.
Pray to god nobody asked me any questions.
I was the best teacher ever.
Deleted User
Yeah. That why my surprise. So the overall yield on the treasuries are falling AND the yield less credit risk is falling as a percentage of that. The CDS spread is pretty important when you take teh CDS into account.
Black Swan Wrote:
——————————————————-
> Okay, so is it correct to say then that if you are
> calculating the risk free rate you should be using
> the treasury rate minus the CDS spread?
Interesting, I never thought of that… though I guess you also need a CDS on the counterparty and then on the counterparty’s counterparty… probably you can find some converging series or something.
You want a quote? Haven’t I written enough already???
Matt, In your calculation you are saying spread equals probability of default, which is not correct. By that rationale, there wouldn’t be a spread over 100 bp. That is a flawed assumption. Just PV your cash flows. Pay 2 bp on 10mm for 5yrs, receive 44 bp on 10mm for 5 yrs, assuming an instantaneous unwind of the position.
Deleted User
I couldn’t find it on the CME website. Anyone have any luck?
Deleted User
grover33 Wrote:
——————————————————-
> Matt, In your calculation you are saying spread
> equals probability of default, which is not
> correct. By that rationale, there wouldn’t be a
> spread over 100 bp. That is a flawed assumption.
> Just PV your cash flows. Pay 2 bp on 10mm for
> 5yrs, receive 44 bp on 10mm for 5 yrs, assuming an
> instantaneous unwind of the position.
You are the CDS buyer, so you are paying those amounts looking for the default to occur. You need to get a reasonable expectation of the probability of default to gauge the value of the swap should there be default. As this probability is completely unknown, we must only use this spread as our gauge for the probability of default as it is our instrument that attempts to price what a default would cost those who risk to protect against it. I don’t see how using an increase in the spread doesn’t help gauge the probability of default. I’m not saying that a 25x increase in the spread means a 25x increase in value, but I will stand by the fact that a 25x increase in the spread represents a large increase in the probability of default in UST, whether it be in perception of those who are buying this device, or in actuality.
Using your rationale of closing the swap out and receiving 42bps at that piont, your return is 100% correlated to the new price of the device which measures the risk of default so is 100% correlated to the risk of default.
Interesting post. Theoretically 0, I believe in reality 0 as well for the time being.
I used to smoke pot and go to class.
Sneak in ten minutes late with a bullsh*t excuse.
Slink down low at my desk.
Pray to god nobody asked me any questions.
I was the best teacher ever.
Black Swan Wrote:
——————————————————-
> Interesting post. Theoretically 0, I believe in
> reality 0 as well for the time being.
nope. i see the 5yr quoted ~ 35bps. was 5bp about a year ago.
http://www.nakedcapitalism.com/2008/11/cds-pricing-in-increasing-treasur...
ps. i used a live market.
Who would buy these?
Of course it’s not theoretically 0. In reality it should be 0, but it’s not. Note that it should be 0 not because the US Gov’t can’t default, but that no trading counterparty would exist to pay if you off in the event of default. However, the instruments exists to play the relative changes in treasury pricing.
Me. If they’ve gone up 25x in one year.
I’ve suggested to my boss that this would be the ultimate hedge on your equity portfolio as equity will only take a huge loss should there be doubt in the system as a whole.
MattLikesAnalysis Wrote:
——————————————————-
> Me. If they’ve gone up 25x in one year.
the spread has widen but you would not have made that much. maybe 1% (without modelling) if you bought these.
NakedPuts Wrote:
——————————————————-
> Of course it’s not theoretically 0. In reality it
> should be 0, but it’s not. Note that it should be
> 0 not because the US Gov’t can’t default, but that
> no trading counterparty would exist to pay if you
> off in the event of default. However, the
> instruments exists to play the relative changes in
> treasury pricing.
i agree.
i wish i could put up 0 collateral, and sell $50MM and pocket $200K per year for 5 years… if UST defaults, i do too.
Well thats what I meant.. the spread increased 25x…
hmmm.. I wonder if we could lever ourselves up huge on these so that you can capture that 25x.. buy and sell options on these…
Who would pay for these to cover their Treasury debt if it doesn’t actually protect from default? I mean, people have to be buying these for the spread to widen…
MattLikesAnalysis Wrote:
——————————————————-
> Who would pay for these to cover their Treasury
> debt if it doesn’t actually protect from default?
> I mean, people have to be buying these for the
> spread to widen…
why not just sell 5 year UST futures? you can leverage there.
If Rome can fall so can the US and the economic/political world didn’t disappear from Rome’s “default”.
It is the global marketplace and there could still be wealth in a bankrupt country should the rules of private property remain in place and the monetary system is not completely inflated to the point where default is prevented but currency is destroyed.
If the government defaults, I think that we have many more problems to worry about. The money you would make on the default swap would probably be nearly worthless anyway.
JustPass Wrote:
——————————————————-
> Who would buy these?
Someone who thinks that the counterparty will pay up when the US Government can’t. I guess the counterparty must be North Korea, who makes the world’s best $100 bills.
I hadn’t thought about buying to capture spread changes. That seems quite risky to me because underlying default is probably highly correlated to conterparty default.
You want a quote? Haven’t I written enough already???
ConvertArb Wrote:
——————————————————-
> MattLikesAnalysis Wrote:
> ————————————————–
> —–
> > Me. If they’ve gone up 25x in one year.
>
>
> the spread has widen but you would not have made
> that much. maybe 1% (without modelling) if you
> bought these.
Would you really only get a 1% return should the spread move up by 25x? Whats the calculation here?
bchadwick Wrote:
——————————————————-
> JustPass Wrote:
> ————————————————–
> —–
> > Who would buy these?
>
> Someone who thinks that the counterparty will pay
> up when the US Government can’t. I guess the
> counterparty must be North Korea, who makes the
> world’s best $100 bills.
>
>
> I hadn’t thought about buying to capture spread
> changes. That seems quite risky to me because
> underlying default is probably highly correlated
> to conterparty default.
Maybe the bet isn’t about waiting until default, but waiting until the market prices most of the default in… Is it possible to have a public sector default and a running private sector? hehe. government bailout by corporations… mmm, facsism.
You could buy a CDS on your counterparty as well..?
MattLikesAnalysis Wrote:
——————————————————-
> Where can I find pricing for these?
Try CMA, a subsidiary of CME Group, which has a product called Quote Vision - it’s a price discovery service that takes all the thousands of emails a trader receives and creates a dashboard of prices. Not sure if they cover US Treasuries, but based on how their technology works, I don’t see why not.
Quote Vision - buy side
Data Vision - risk management/research
MattLikesAnalysis Wrote:
——————————————————-
> ConvertArb Wrote:
> ————————————————–
> —–
> > MattLikesAnalysis Wrote:
> >
> ————————————————–
>
> > —–
> > > Me. If they’ve gone up 25x in one year.
> >
> >
> > the spread has widen but you would not have
> made
> > that much. maybe 1% (without modelling) if you
> > bought these.
>
> Would you really only get a 1% return should the
> spread move up by 25x? Whats the calculation here?
you have to make some kind of assumptions here. let’s assume 40% recovery. I will model these out from 5 to 35bps.
At 5bps, an equlivent bond priced off the swap curve would be 99.76 using JP Morgan Model.
At 35bps, an equlivent bond priced off the swap curve would be 98.35
move of about 1.5 pts.
I’m thinking of this from a different POV.
Taking the actual prices of the spread from the link given above and being conservative (the move was a 25x increase, so lets assume 2bps and 44 bps for whole number sake)
So at 2bps.
You would have to pay $0.02 for every $100 of protection annually or $0.20 over a 10 years contract. Assuming the spread in the CDS dictates the probability of default, then the expected return in event of default is 0.002 x $60 (recovery rate) - $0.20 (cost of contract over its life) which equals -$0.08. So at this point there is a premium for the purchase of the contract due to the recovery rate assumption.
At the new price of 44bps:
You would have to pay $0.44 for every $100 of protection annully or $4.40 over the life of the contract. The expected return paying the $0.02/yr would be 0.044 x $60 - $0.20 equalling $2.44.
Wouldn’t the increase be approximately 25x as the probablility of default has come up and you have no investment except for the payments on the swap? The value of the $0.02/yr swap is now much higher as an equivalent swap now costs $0.44/yr.
Mind you, these probabilities are very primative yet there is some conservative calculation as this assumes all payments are made, although payments would stop when default occurs.
“Assuming the spread in the CDS dictates the probability of default,”
when is this the case?
actually it is the case but the math after that is what i have trouble with… the spread is the market, using the market you can then get a default probability, at a 5bps spread i get the arb free probability of 0.43% over the 5 year contract using 40% recovery.
Why would someone pay 25x more for something if the probability hasn’t increased dramatically?
The only idea about the probability of UST default is through what people will pay to protect against it.
Where are you getting your probabilities?
and if you can, can you calculate one for a 125 bps spread to compare to the 5bps spread?
Okay, so is it correct to say then that if you are calculating the risk free rate you should be using the treasury rate minus the CDS spread?
I used to smoke pot and go to class.
Sneak in ten minutes late with a bullsh*t excuse.
Slink down low at my desk.
Pray to god nobody asked me any questions.
I was the best teacher ever.
Yeah. That why my surprise. So the overall yield on the treasuries are falling AND the yield less credit risk is falling as a percentage of that. The CDS spread is pretty important when you take teh CDS into account.
Weird to say the least…
Black Swan Wrote:
——————————————————-
> Okay, so is it correct to say then that if you are
> calculating the risk free rate you should be using
> the treasury rate minus the CDS spread?
Interesting, I never thought of that… though I guess you also need a CDS on the counterparty and then on the counterparty’s counterparty… probably you can find some converging series or something.
You want a quote? Haven’t I written enough already???
Matt, In your calculation you are saying spread equals probability of default, which is not correct. By that rationale, there wouldn’t be a spread over 100 bp. That is a flawed assumption. Just PV your cash flows. Pay 2 bp on 10mm for 5yrs, receive 44 bp on 10mm for 5 yrs, assuming an instantaneous unwind of the position.
I couldn’t find it on the CME website. Anyone have any luck?
grover33 Wrote:
——————————————————-
> Matt, In your calculation you are saying spread
> equals probability of default, which is not
> correct. By that rationale, there wouldn’t be a
> spread over 100 bp. That is a flawed assumption.
> Just PV your cash flows. Pay 2 bp on 10mm for
> 5yrs, receive 44 bp on 10mm for 5 yrs, assuming an
> instantaneous unwind of the position.
You are the CDS buyer, so you are paying those amounts looking for the default to occur. You need to get a reasonable expectation of the probability of default to gauge the value of the swap should there be default. As this probability is completely unknown, we must only use this spread as our gauge for the probability of default as it is our instrument that attempts to price what a default would cost those who risk to protect against it. I don’t see how using an increase in the spread doesn’t help gauge the probability of default. I’m not saying that a 25x increase in the spread means a 25x increase in value, but I will stand by the fact that a 25x increase in the spread represents a large increase in the probability of default in UST, whether it be in perception of those who are buying this device, or in actuality.
Using your rationale of closing the swap out and receiving 42bps at that piont, your return is 100% correlated to the new price of the device which measures the risk of default so is 100% correlated to the risk of default.
a=b=c
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