Credit default swap is one of the most traded product. CDS , CDS indices , CDS swaptions have become very important tool for banks to hedge their counter party risk. To reduce the earning volatility driven by CVA, banks uses CDS or CDS indices.
Basics of CDS -
1) When someone buy CDS then it means that he has bought the protection on credit risk of reference entity. Buyer will pay the agreed premium to the seller. Buyer will have to pay this premium until expiry of trade or if credit event occurs.
2) Seller of CDS buy the credit risk of reference entity and he will earn premium from the buyer of CDS. Seller has to pay the (1-RR)*notional amount to buyer if credit events occurs.
3) Seller of CDS makes profit if spreads tightens on the reference entity and buyer will be losing the same amount of money by spreads tightens.
4) Spreads are normally based on one reference rate i.e. Libor. CDS spreads are very tightly coupled with bond spreads. Market Quotes of premium of liquid CDS are driven by the arbitrage relationship with bond spreads rather than from any model.
Motivation for trading CDS-
1) To hedge the counterparty risk
2) Market maker buy and sell CDS to earn the spreads.
3) To exploit the arbitrage between bond spreads and CDS spreads though these markets are closely related because of active arbitrage traders.
4) Index skew trading or to earn spreads between on the run and off the run issues.
Any derivative or structured product can be best understood if you can replicate risk and return profile of this product with simple products. CDS can be replicated using the bond that is funded by the borrowing.
CDS is not a funded product as buyer do not have to pay the notional amount of the CDS to the seller but bond is the funded product so to replicate the CDS with the bond, bond has to be bought using the borrowed money.
To replicate a CDS (selling protection, for example) using bond market instruments, we can buy a par floating rate note or an asset-swapped fixed-rate par bond1 and borrow money to fund the purchase. The resulting risk profile of this package is similar to that of a CDS: long credit risk with interest rate risk hedged (there are, however, certain differences, which we illustrate at the end of this section). The resulting cash flow profile is also similar.
However there are certain subtle differences in these two. More on this is explained in Credit Default swaps. Arbitrage relationship also depends on the funding cost of the firm as different firms have different funding cost because of their creditability. CDS spreads of a distressed entity do not directly related to bond spreads of that entity. We will discuss both the points in next post.
Basics of CDS -
1) When someone buy CDS then it means that he has bought the protection on credit risk of reference entity. Buyer will pay the agreed premium to the seller. Buyer will have to pay this premium until expiry of trade or if credit event occurs.
2) Seller of CDS buy the credit risk of reference entity and he will earn premium from the buyer of CDS. Seller has to pay the (1-RR)*notional amount to buyer if credit events occurs.
3) Seller of CDS makes profit if spreads tightens on the reference entity and buyer will be losing the same amount of money by spreads tightens.
4) Spreads are normally based on one reference rate i.e. Libor. CDS spreads are very tightly coupled with bond spreads. Market Quotes of premium of liquid CDS are driven by the arbitrage relationship with bond spreads rather than from any model.
Motivation for trading CDS-
1) To hedge the counterparty risk
2) Market maker buy and sell CDS to earn the spreads.
3) To exploit the arbitrage between bond spreads and CDS spreads though these markets are closely related because of active arbitrage traders.
4) Index skew trading or to earn spreads between on the run and off the run issues.
Any derivative or structured product can be best understood if you can replicate risk and return profile of this product with simple products. CDS can be replicated using the bond that is funded by the borrowing.
CDS is not a funded product as buyer do not have to pay the notional amount of the CDS to the seller but bond is the funded product so to replicate the CDS with the bond, bond has to be bought using the borrowed money.
To replicate a CDS (selling protection, for example) using bond market instruments, we can buy a par floating rate note or an asset-swapped fixed-rate par bond1 and borrow money to fund the purchase. The resulting risk profile of this package is similar to that of a CDS: long credit risk with interest rate risk hedged (there are, however, certain differences, which we illustrate at the end of this section). The resulting cash flow profile is also similar.
However there are certain subtle differences in these two. More on this is explained in Credit Default swaps. Arbitrage relationship also depends on the funding cost of the firm as different firms have different funding cost because of their creditability. CDS spreads of a distressed entity do not directly related to bond spreads of that entity. We will discuss both the points in next post.
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