Subject 4. Applications of CDS PDF Download
There are two major applications of CDS.
- Exploit an expected movement in the underlying bond.
- Valuation differences between the bond and CDS.
CDS can be used to hedge existing exposures to credit risk. It can be used to manage credit risk without necessitating the sale of the underlying cash bond. For example, owners of a corporate bond can protect themselves from default risk by purchasing a CDS on that reference entity.
For the CDS seller, the trade adds credit exposure. The seller can manage its credit exposure by either diversifying its credit risks or hedging the risk by entering into an offsetting transaction with another party.
CDS has enabled investors to short credit easily and speculate on changes in credit spreads. It allows investors to express views either way on credit because investors are not constrained by the "borrow":
- Buy protection = "short credit".
- Sell protection = "Long credit".
Credit risk can be managed separately from other risks such as interest rate risk.
Naked credit default swap: Buying credit protection with no exposure to the reference entity.
- The buyer speculates that the reference entity's credit quality will deteriorate.
- The seller speculates the opposite.
CDS trading strategies:
- Outright long or short position.
- Long/short trade. Long a CDS on one reference entity and short a CDS on another reference entity. The strategy is known as "spread" in options and futures trading.
- Curve trade. A type of long/short trade, it involves buying a CDS of one maturity and selling a CDS on the same reference entity with a different maturity.
- Basis trade. It involves exploiting differences in pricing between the CDS and the underlying bond. Ideally, the credit risk portion of the yield on the bond issued by the reference entity should be equal to the credit spread on a CDS. When they are different, the investor can buy one and sell the other, and capture the profit.
- Credit spread strategy in LBO. When a company undergoes a LBO, an investor can buy its stock and purchase CDS protection - its credit spread will increase when it takes additional debt.
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