Explainer: Is CDS an accurate indicator of default risk?

The country's five-year credit default swap (CDS) - a type of insurance against the risk of sovereign default - increased by almost 20 percentage points on a day-on-day basis to a multi-year high of 75.5 per cent on Nov 15.

It took hardly any time to turn the 11-word message into a well-padded story. Then came the onslaught of YouTube videos on the impending sovereign default, and before you could say 'verified information', former PM Imran Khan began using this chatter to set off alarm bells in public rallies about a certain sovereign default. In response, Finance Minister Ishaq Dar broke his silence on Saturday and called such concerns baseless.

But what is the CDS and is it an indicator of default risk?

A CDS works like an insurance policy to protect investors (read: bondholders) from any loss arising out of a country's inability to pay back its dollar-denominated loan.

Say an investor buys a bond and also goes to an investment bank to buy its CDS. They sign a formal swap agreement under which the bank promises - against a fee or premium - to compensate the bondholder should the bond-issuing sovereign default.

The important bit to understand here is that these figures are bought and sold in the over-the-counter (OTC) market, which has no proper exchange. Hence, there's no singular CDS rate. It's compiled and issued by different organisations, just like Pakistani brokers compile the closing exchange rate for the open market every day.

One would assume that the premium - or the CDS level - should range anywhere between a few basis points and a few percentage points. But that's not the case with Pakistan's international debt, given its myriad problems. Hence, the mindboggling 75.5pc CDS figure.

In other words, it means a bondholder should, on average, $pay 75.50 to an investment bank to secure or insure every $100 that it's lending to the government of Pakistan.

But how real is this number and in which universe does it make sense to protect a $100 investment by paying a $75 fee?

'The CDS level shows the cost of insuring against default. It doesn't tell the probability of default,' Alpha Capital Securities CEO Muhammad Azfer Naseem told Dawn on Saturday.

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