Why looking at the CDS market is interesting
A Credit Default Swap (CDS) insures against losses stemming from a credit event. In the context of countries, the contract protects against the default of the issuing sovereign. The premium (spread) which the protection buyer (e.g. a bank) pays to the protection seller (e.g. an insurance company) is determined by market forces and depends on the expected default risk of the respective country.
Therefore, CDS spreads are an indicator of the market's current perception of sovereign risk. Notice though that CDS spreads also depend on other factors such as market liquidity, counterparty risk and the global financial environment, in particular US interest rates and global risk appetite.
DB Research translates CDS spreads into implicit default probabilities online so that they can be interpreted in a straightforward manner: for example, a spread of 200 basis points is equivalent to the notion that the market is pricing in an annual chance of about 3% that the issuing government will default.
Notice that one has to make an assumption about the expected recovery rate for such computations - in the example, we used a 40% recovery rate which is the market convention for the quotation of many CDS contracts. In the online application, the recovery rate assumption can be varied by the user. Also note that the higher the assumption about the recovery rate, the higher the implicit default probability.
>>>Computations behind Sovereign default probabilities online (pdf)
Kevin Körner, +49 69 910-31718