CDS Applications and the Basis Trade
Credit default swaps have several uses for several types of market participants. Just like many other derivatives, they can be used to increase risk or to reduce risk.
Perhaps an investor has a very thinly traded bond from a large issuer. Rather than sell the bond if there's fear of default, the investor might just decide to use a CDS. Which side would be best for reducing risk in this case?
Absolutely!
No, short.
The short in a CDS is the credit protection buyer, and this investor needs to buy some protection if the bond can't easily be sold.
On the long (or credit protection seller) side, a lot of participants are dealers. They sell credit protection like an insurance company and deal with the risk in a similar way. You can diversify across reference entities, and even hedge the risk with an offsetting position.
Not all protection sellers are dealers, though. Think of a bond issuer and a bondholder. The issuer promises the payments and the bondholder purchases the bond, thinking that it's a good deal. Which one of these two is in the most similar position to a credit protection seller?
You got it!
No, actually, it's the bondholder.
The bondholder takes on the risk of a default by hoping cash flows will be paid, saying, "I'll go ahead and take these cash flows and accept the risk." That's exactly what a credit protection seller does by taking that long position in a CDS. So perhaps a potential bondholder decides to take a long CDS position rather than a long bond position.
There are also speculators and combinations. Without any credit exposure, a party might choose to take on a __naked credit default swap__, simply betting one way or the other on the credit of the reference entity.
Or perhaps two entities are priced the same, but a speculator believes that one is safer than the other. This expectation of relative credit risk can be exploited with a __long/short__ trade, taking opposite positions in two different CDS.
Suppose you had a different expectation: with CDS priced according to a flat credit curve, with constant hazard rates, you believed that the risk of default is really much higher in the next year than it will be any time after that. What combination might you want to use to take advantage of this?
No, you'd do just the opposite: long a long-term CDS and short a short-term CDS.
Yes!
This probably took a minute to think about. If you predict short-term danger, then you want to buy protection now, being on the short side of perhaps a two-year CDS, and take a long position in the 10-year CDS. If you're right and years 2 through 10 are event-free, then you get to pocket the difference. If the default takes place, the positions will offset. This is called a __curve trade__, where you buy a CDS of one maturity and sell a CDS of another.
The credit spread that gives CDS their value comes from bond yields. The two are related. But at times, even those spreads show some disagreement. They shouldn't, and if they converge like they are supposed to, you can take advantage of the difference with another combination. This is called a **basis trade**, where a discrepancy in credit spreads between two markets can lead to temporary mis-pricing. Suppose that the credit spread is higher on the CDS than it is on the bond. What would you want to do with the bond?
No, selling would be better.
That's right.
A "too low" bond yield means a "too high" bond price. So sell the bond. Then what would you want to do with credit protection?
A "too low" bond yield means a "too high" bond price. So sell the bond. Then what would you want to do with credit protection?
No, that's still not the right idea. You would want to sell the credit protection.
Right again!
No, it's still "sell," actually. But you were right the first time.
This time you got it!
If you had a bond, you'd want credit protection, since you're relying on the issuer's credit. But no bond, no risk. In fact, you would have the opposite exposure with your short bond position, so this nets out from selling credit protection.
If it helps, consider that this is still a long and short together: in this example, short the bond and long the CDS.
To summarize:
[[summary]]
Long
Short
The issuer
The bondholder
Long a long-term CDS and short a short-term CDS
Long a short-term CDS and short a long-term CDS
Buy
Sell
Buy credit protection
Sell credit protection
Buy credit protection
Sell credit protection
Continue
Continue
Continue
Continue
