Distressed Volatility

I knew there were treasury interest rate swaps, but treasury credit default swaps? You've heard in the news that credit default swap spreads (ability to swap defaulted debt securities w/ a counterparty at par) have been spiking due to the large amount of banks going under. The interest rate spread, or swap spread priced in basis points, is the cost of protecting the debt from default. The swap spread increases as the default risk of the underlying security increases. There are U.S Treasury Default Swaps quoted in euros. You can find real time data at CMA DataVision or the Bloomberg Professional service for a fee. With the thought of almost a $trillion in government bail out money passing congress, it looks like people are starting to bid up U.S Treasury Default Swaps due to the current state of the U.S balance sheet. Here is a chart sourced from the article "A default by the US government is no longer unthinkable" from telegraph.co.uk on 9/20/2008. The chart is no long available with that article, but I found it somewhere else. Also Treasury CDS spreads hit a new record 4 days later (9/24/2008 Reuters article below).

"US 10-year Treasury CDS widens to record 29.2 bps-CMA
Wed Sep 24, 2008 6:28am EDT

LONDON, Sept 24 (Reuters) - The cost of insuring 10-year U.S. government debt against default rose to a record high on Wednesday as investors fretted over the feasibility of the government's $700 billion plan to contain the financial crisis. Credit default swaps on 10-year Treasury debt expanded to 29.2 basis points -- its widest ever -- from 26.5 basis points on Tuesday, according to CMA, a specialised data provider. CMA said CDS on five-year widened to 22.0 basis points from 20.5 basis points. (Reporting by Emelia Sithole-Matarise)"

Credit ratings agencies, like Moody's and S&P, also have an effect on the pricing of risk, or swap spreads in this case. When they lower the rating on an entities debt, interest rates rise as investors demand higher payments for the extra risk. Recently Moody's and S&P have thought about lowering the AAA rating on U.S government debt possibly in the next 10 years if they keep piling on trillions of debt. That's what is happening here, swap spreads are widening because risk is being repriced appropriately.

"S&P says pressure building on U.S. "AAA" rating
Wed Sep 17, 2008 5:29pm EDT

NEW YORK (Reuters) - Pressure is building on the pristine "AAA" rating of the United States after a federal bailout of American International Group Inc, the chairman of Standard & Poor's sovereign ratings committee said on Wednesday. The $85 billion bailout of AIG on Tuesday by the U.S. Federal Reserve "has weakened the fiscal profile of the United States," S&P's John Chambers told Reuters in an interview. "Lack of a pro-active stance could have resulted in further financial stress and put pressure on the U.S. triple-A rating," Chambers said. "There's no God-given gift of a 'AAA' rating, and the U.S. has to earn it like everyone else." The cost of insuring 10-year U.S. Treasury debt against default rose on Wednesday to a record high, a day after the government rescued insurer AIG with an $85 billion loan. At one time, AIG was the world's largest insurer, ranked by market value. At midday on Wednesday, AIG's stock was down 33 percent at $2.50 on the New York Stock Exchange. Ten-year credit default swaps, or CDS, on Treasury debt widened 3 basis points to 26 basis points, according to data from CMA DataVision. This means it costs $26,000 per year to insure $10 million of U.S. Treasury debt against default. Five-year credit default swaps on Treasury debt were steady at 21.5 basis points. That compares to 9.8 basis points on German 5-year CDS and 13.2 basis points on German 10-year CDS, CMA said. Earlier this month, S&P affirmed the "AAA" sovereign rating of the United States, noting risks to the U.S. credit profile, including the deteriorating credit profiles for most U.S. financial institutions over the past 12 months, S&P said in a September 3 statement........click for more article."

Credit Default Swaps on U.S (BloombergTV:7/21/08)