Credit Derivatives Research LLC recently launched a new Government Risk Index ("GRI"), which measures the creditworthiness of leading sovereign debtors, based upon their five-year credit default swap ("CDS") spreads, reported by Index Universe here. We followed the story up by an interview with Dave Klein, CDR's manager of indices.

IU.eu: Dave, how did you decide on the components for the GRI? You've included six of the seven G7 countries, but substituted Spain for Canada.

Klein: We were interested in the higher-rated sovereigns with a large volume of outstanding debt. We looked the debt available in a couple of different ways and these seven countries (US, Japan, Germany, France, UK, Italy, Spain) were the obvious choices. Also, Canada as a sovereign doesn't have a very liquid CDS market.

IU.eu: How are the countries weighted in the index?

Klein: The index is based on a simple average of the seven sovereigns' CDS rates. We do have a cap in place if one sovereign's CDS spread blows out to very high levels.

IU.eu: Why have you chosen the five-year maturity CDS as the basis for the sovereign risk spreads?

Klein: Up until about six months ago there was actually more liquidity in the ten-year CDS for many sovereign names, but since then trading activity in the five-year contract has really taken off, and so we use that as the benchmark.

IU.eu: CDS spreads for sovereign debtors are different, depending on whether the contract is denominated in the borrower's own currency, or in a foreign currency. If in the domestic currency, spreads are lower, as there is less risk of an outright default (since the government can usually inflate away debts in its own currency). How have you dealt with this?

Klein: We use the foreign-denominated CDS for each issuer. For the US CDS the market convention is to quote in a euro-denominated contract. For the other six members of the GRI we use the dollar-denominated CDS, which again represents the liquid contract for each borrower.

You've highlighted one of the differences between the sovereign CDS market and the corporate CDS market. For corporate CDS the currency consideration shouldn't play much of a role. That's also why it's worth reminding ourselves that a given CDS spread, say 100 basis points, for a government is not directly comparable to a 100 basis point CDS spread for a corporate.

In a standard, corporate credit derivatives model you can work out a default probability for a company directly from the CDS spread, with a couple of assumptions about the recovery rate and interest rates over the period of the swap. You can't do that in exactly the same way for a sovereign debtor - there are additional assumptions to make, for example the one you've highlighted on currency. For that reason we don't try to work out default probabilities within the GRI.

That doesn't invalidate the point of the index, though. It's proving particularly useful as a measure of trends in government creditworthiness. The GRI rose a lot from the beginning of 2008 to its peak in March this year, particularly after the Lehman collapse. Since then it's fallen back quite a bit, as concerns over government creditworthiness have eased.

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