Prices on credit default swaps suggest that markets are pricing for an Italian default about two years from now, according to Italian economists Paolo Manasse and Giulio Trigilia in a report published in VoxEU.
They produced this complicated graph that explains all of this. Here’s how to read it:
- From southwest to northeast (time versus conditional default probabilities), you can see the probability of default for a CDS contracts. You’ll see that default probabilities fell early this year before starting to spike around June-July. These are then integrated across a variety of maturity dates.
- Running northwest to southeast, check out the default probabilities for CDS contracts of different maturities. Right now, this probability is much higher for securities of one or two years than for those where contracts would be paid out in three or more years.
This chart (particularly the second feature listed above) shows that investors are far more bearish about a near-term default than they are one three years or more down the road.
Manasse and Trigilia suggest that this is because the possibility of political catastrophe in Italy right now is escalated, particularly after the ouster of Silvio Berlusconi. If Italy can make it through the next two years, however, investors seem to think that the probability of default will decline sharply—essentially, Italy will have found a solution.
Check out the graph: