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Sovereign Debt and Credit Default Swaps (CDS)

 

🔹 What is Sovereign Debt?

Sovereign debt refers to money borrowed by a national government, usually through the issuance of bonds. This debt can be denominated in local currency (e.g., Indian government issuing rupee bonds) or foreign currency (e.g., Argentina issuing dollar bonds).

Types of Sovereign Debt:

  • Domestic Debt – Issued in the country's own currency and legal system.

  • External (Foreign) Debt – Issued in foreign currencies and often governed by foreign legal systems.

Why Do Governments Borrow?

  • To fund infrastructure and social programs.

  • To cover budget deficits.

  • To respond to emergencies or economic crises.


🔹 Risks of Sovereign Debt

Governments, like corporations, can default—fail to meet their debt obligations. Common reasons:

  • Political instability.

  • Economic collapse or currency crisis.

  • High debt-to-GDP ratio.

Notable Sovereign Defaults:

  • Argentina (2001, 2014)

  • Greece (2010s during the Eurozone crisis)

  • Russia (1998)


🔹 What is a Credit Default Swap (CDS)?

A Credit Default Swap is a financial derivative that allows investors to protect themselves against the risk of a borrower (like a government) defaulting on its debt.

How It Works:

  • A buyer of CDS pays a premium (like insurance) to a seller.

  • If the referenced country defaults, the seller compensates the buyer.

  • If there is no default, the seller keeps the premium.

CDS is essentially insurance against credit risk.


🔹 Key Terms in CDS:

Term Definition
Premium (Spread) Annual cost of the CDS as a % of notional value (e.g., 300 basis points = 3%)
Reference Entity The borrower (e.g., Brazil, Turkey)
Credit Event Default, restructuring, or failure to pay
Notional Amount Amount being insured (e.g., $10 million bond)

🔹 How Sovereign CDS Affects Markets

  1. Market Signal: Rising CDS spreads = higher perceived risk of default.

  2. Investor Behavior: CDS can be used for speculation or hedging.

  3. Cost of Borrowing: High CDS spreads can lead to higher bond yields for governments.

  4. Contagion Risk: Sovereign debt crisis in one country can spread to others via CDS exposure.


🔹 Benefits of CDS in Sovereign Debt Markets

  • Enables risk management for lenders and investors.

  • Adds liquidity to the debt market.

  • Provides market-based assessment of a country’s credit risk.


🔹 Criticism of CDS

  • Speculation: CDS can be bought without owning the underlying debt (“naked CDS”), increasing volatility.

  • Opacity: Lack of transparency in the OTC market.

  • Systemic Risk: Interconnected positions can magnify shocks during financial crises.


🔹 Example

A US investor holds $10 million in Turkish government bonds. To protect this investment:

  • They buy a 5-year CDS from a bank for 400 basis points (4% per year).

  • Each year, they pay $400,000.

  • If Turkey defaults, the bank pays them the $10 million (less recovery value).


✅ Summary Table

Concept Description
Sovereign Debt Loans/bonds issued by national governments
CDS Derivative contract protecting against default
CDS Spread Measures credit risk (higher = riskier)
Uses Hedging, speculation, risk pricing
Risks Speculation, systemic risk, opacity

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