Efficient market hypothesis says that if markets are efficient then the price that is determined takes into account all the information that is available to the players including perceptions. Trading then takes place based on these prices as all market participants believe that they are the right ones and they are willing to put their money on the table based on these outcomes. Intuitively, the price traded is reflective of the perception of the subject that is involved. Now, if this concept is translated into the sovereign CDS (credit default swap) market, then we can say with confidence that the swap rates are the revealed rates at which players are actually buying and selling protection. High swap rates mean that there is a high perception of risk which has to be compensated while low rates mean there is less risk.
Now, these market perceptions can be juxtaposed with the ratings given by credit rating agencies. Rating agencies have their own models for determining what should be the rating accorded to a nation. The question asked is, what is the probability of default in servicing a debt emanating from a nation. There are subjective and objective factors that go into this decision. The CDS rate, on the other hand, is what the market thinks of the same risk. And, when one buys the swap, there is a cost involved which both the parties agree on. These rates are variable and change with the economic environment.
For an academic discussion, these swap rates can be compared with the ratings accorded by rating agencies to see if there is deviation in perception. The CDS rate has been taken for September 21. The AAA-rated countries are the UK, Switzerland, Sweden, the Netherlands and Germany whose 5-year CDS rate varies from 30 bps for Sweden to 60 bps for Netherlands. These should be the lowest rates as they are perceived to have the lowest risk in the market. However, the US has a lower rating but the swap rate is just 30 bps.
At the next highest level is the AA+ category which includes Austria. The country has a swap rate of 68 bps. But, France with the same rating has a CDS rate of 105 bps and the market views France as being more unstable to price the risk higher. The anomaly becomes starker when we look at, say, Japan which has a rating of AA- with a CDS rate of 83 bps while China with the same rating goes with 173 bps and Belgium with a rating of AA goes with 113 bps. The market is, hence, more confident about Japanese government bonds compared with, say, China, though the rating is the same. Korea is rated A, but has a swap rate of 80 bps which should have been closer to the AA sovereign rating. Curiously, Indonesia, with a swap rate of 142 bps, which is lower than China has a rating of BBB- and Italy with 320 bps has a rating of BBB+.
What is one to make of these anomalies considering that in both cases there is a risk assessment - one made by professionals and the other by market forces? Actual trading of risk is based on the market which finally could matter for those who seek or give cover. Since all governments do not raise money globally or have vibrant sovereign CDS markets for their bonds, the swap rate answers questions on risk perception when the market exists. Otherwise, the rating accorded by the agency is the only option to judge risk.
Now, these market perceptions can be juxtaposed with the ratings given by credit rating agencies. Rating agencies have their own models for determining what should be the rating accorded to a nation. The question asked is, what is the probability of default in servicing a debt emanating from a nation. There are subjective and objective factors that go into this decision. The CDS rate, on the other hand, is what the market thinks of the same risk. And, when one buys the swap, there is a cost involved which both the parties agree on. These rates are variable and change with the economic environment.
For an academic discussion, these swap rates can be compared with the ratings accorded by rating agencies to see if there is deviation in perception. The CDS rate has been taken for September 21. The AAA-rated countries are the UK, Switzerland, Sweden, the Netherlands and Germany whose 5-year CDS rate varies from 30 bps for Sweden to 60 bps for Netherlands. These should be the lowest rates as they are perceived to have the lowest risk in the market. However, the US has a lower rating but the swap rate is just 30 bps.
At the next highest level is the AA+ category which includes Austria. The country has a swap rate of 68 bps. But, France with the same rating has a CDS rate of 105 bps and the market views France as being more unstable to price the risk higher. The anomaly becomes starker when we look at, say, Japan which has a rating of AA- with a CDS rate of 83 bps while China with the same rating goes with 173 bps and Belgium with a rating of AA goes with 113 bps. The market is, hence, more confident about Japanese government bonds compared with, say, China, though the rating is the same. Korea is rated A, but has a swap rate of 80 bps which should have been closer to the AA sovereign rating. Curiously, Indonesia, with a swap rate of 142 bps, which is lower than China has a rating of BBB- and Italy with 320 bps has a rating of BBB+.
What is one to make of these anomalies considering that in both cases there is a risk assessment - one made by professionals and the other by market forces? Actual trading of risk is based on the market which finally could matter for those who seek or give cover. Since all governments do not raise money globally or have vibrant sovereign CDS markets for their bonds, the swap rate answers questions on risk perception when the market exists. Otherwise, the rating accorded by the agency is the only option to judge risk.
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