What it means
A credit default swap (CDS) is a contract in which one party pays a regular fee to another in exchange for compensation if a borrower fails to pay its debts. A CDX index bundles many such contracts into one tradable product.
Instead of buying protection on each company separately, an investor buys or sells protection on the whole basket. The CDX family includes indices for investment grade companies, high yield companies (those with weaker credit ratings) and emerging markets.
Each index has a series number, and a new series is launched periodically as the list of companies is updated. Traders therefore refer to the on-the-run series, which is the most recent and most actively traded.
Pricing works through a fixed coupon, which is the annual fee paid by the protection buyer, and a market spread, which moves with perceived risk. When the spread rises above the coupon, the buyer of protection is owed an upfront payment to compensate for the difference.
When the spread is below the coupon, the buyer pays the seller upfront. The indices are widely used as barometers of market stress.
A sharp widening in the investment grade index signals that investors are demanding more compensation for credit risk, and it often accompanies falling equity markets. Corporate treasurers also watch them to judge the likely cost of new bond issues.
Users should remember that these are over-the-counter instruments with counterparty and basis risks, and that rules and branding of index families can change over time. Hedging a specific loan with an index leaves some risk behind, because the individual borrower may behave differently from the basket.
For that reason, the indices suit portfolio-level hedging better than the protection of a single exposure.
In practice
Real-world examples.
Example
A pension fund holds a diversified portfolio of corporate bonds worth $200,000,000. Worried about a recession, its risk team buys protection on an investment grade CDX index. If credit spreads widen, the gain on the index offsets some of the loss on the bonds.
Example
A hedge fund believes that high yield defaults will rise over the next year. It buys protection on a high yield CDX index and does not need to pick individual companies. The fund profits if the index spread widens.
Example
A corporate treasurer planning a bond issue checks the investment grade index each morning. When the spread jumps by 20 basis points in a week, she delays the issue by a month. She wants to avoid paying a higher coupon at a time of stress.
Formula
Calculation
Upfront payment = (Market spread - Fixed coupon) x Risky duration x Notional amount
Worked example: an investor buys protection on $10,000,000 of an investment grade index. The fixed coupon is 100 basis points (1.00%), the market spread is 130 basis points (1.30%) and the risky duration (the sensitivity of the price to spread changes, roughly the present value of one basis point of spread) is 4.5 years.
Step 1: Spread difference = 1.30% - 1.00% = 0.30% = 0.0030
Step 2: Multiply by the duration = 0.0030 x 4.5 = 0.0135
Step 3: Multiply by the notional = 0.0135 x $10,000,000 = $135,000
The protection seller pays the buyer $135,000 upfront, because the market charges more than the fixed coupon, and the buyer continues to pay 1.00% a year.Case study
Seen in the real world.
Windermere Capital is an illustrative, fictional asset manager with a $500,000,000 corporate bond fund. The chief risk officer worried that credit spreads were unusually tight and that investors were not being paid for the risk.
She bought $50,000,000 of protection on an investment grade index at a spread of 70 basis points. Over the next quarter, concerns about slowing growth pushed the spread to 100 basis points.
The index position gained value, partly offsetting a fall in the price of the bonds. The illustrative lesson is that an index hedge cannot remove risk entirely, but it can soften the impact of a broad move in credit markets without selling the underlying bonds.
Watch out
Common mistakes.
- Assuming the index tracks the price of company shares, when it tracks the cost of insuring against defaults on debt.
- Treating an index hedge as a perfect match for one loan, when the basket and the single borrower can behave differently.
- Ignoring the series and roll, when new series replace old ones and liquidity moves to the latest series.
Questions
People also ask.
What does CDX stand for?
It is the name of a family of credit default swap indices that cover North American and emerging market issuers, and the letters are best read as a product name.
What does it mean when the spread widens?
It means the market is charging more to insure against default, which signals higher perceived credit risk.
Who trades these indices?
Banks, asset managers, hedge funds, insurers and corporate treasuries trade them to hedge credit exposure or to speculate on credit conditions.
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