Over the past few years, the financial world has turned to the CDS market for a gauge on default risk of specific debt issues. If a company or country runs into trouble, we expect CDS spreads to widen. But how well do derivatives gauge default risk?

Fitch performed an analysis that suggests the CDS market is in fact a pretty poor barometer of this risk. It looked at spread changes between July 2007 and August 2010 and found the changes in spreads were an accurate indicator of defaults only for bond insurers. Spread changes tended to overstate the default risk for the REITs, homebuilders, banks and insurance companies.

"In many cases CDS spreads were implying very high default rates and these failed to materialize. It is really important to remember CDS pricing is affected by many factors," a Fitch executive told the Financial Times. "Investors should remember that when they use any tool but this is particularly true for CDS," he said. The fact is that volume is pretty thin even in actively traded CDSs.

For more:
- here's the article

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