Estimated study time: 60 minutes
Content:
A credit default swap (CDS) is a bilateral contract in which the protection buyer pays periodic premiums (the CDS spread) to the protection seller in exchange for a payment contingent on a credit event affecting a reference entity or reference obligation. The protection buyer is economically short credit risk — it profits if the reference entity's credit quality deteriorates or defaults. The protection seller is economically long credit risk — it profits if no credit event occurs and the premiums are collected in full. CDS fundamentally allow separation of credit risk from interest rate risk, enabling targeted credit risk management without buying or selling the underlying bonds.
The mechanics of a CDS contract include: the reference entity (the company or sovereign whose credit risk is being transferred), the reference obligation (the specific bond defining the seniority and recovery rate applicable to the swap), the notional principal (the face value amount of protection), the CDS spread (premium paid by the protection buyer, quoted in basis points per annum), and the credit events (the triggers for protection payment, typically including bankruptcy, failure to pay, and, for sovereign CDS, restructuring/repudiation). Upon a credit event, settlement can be physical (the protection buyer delivers the defaulted bond and receives par) or cash settlement (based on an auction-determined recovery price; the protection seller pays 100 minus the recovery price times notional). Cash settlement is now standard in the CDS market.
CDS pricing is determined by the credit risk of the reference entity. The CDS spread ≈ PD * LGD (for flat hazard rate, continuous time), mirroring the bond credit spread derivation. In arbitrage terms: Bond yield = Risk-free rate + Credit spread; CDS spread ≈ Bond credit spread. If the bond credit spread significantly exceeds the CDS spread (after adjusting for funding costs and counterparty risk), a negative basis trade is profitable: buy the bond (earning the credit spread) and buy CDS protection (paying the CDS spread) — the net positive carry with minimal credit risk is a convergence trade. If the CDS spread significantly exceeds the bond credit spread, a positive basis trade can be constructed by going long CDS (selling protection) and shorting the bond.
CDS indices aggregate multiple single-name CDS into standardized products. The most prominent is the CDX (North American) and iTraxx (European) families. The CDX IG contains 125 investment-grade North American reference entities; the CDX HY contains 100 high-yield entities. These indices allow traders to take broad credit views (long or short the entire index) without needing to transact in individual names. A protection buyer on CDX IG is short broad investment-grade credit risk — if spreads widen (credit quality deteriorates broadly), the CDS appreciates in value. CDS indices are also used to construct synthetic CDOs (collateralized debt obligations) and for macro credit hedging by bond portfolio managers.
At CFA Level 2, candidates must understand several applied uses of CDS. First, a bond portfolio manager can use CDS to hedge credit risk on existing positions without selling bonds — buying protection on a specific issuer reduces the portfolio's net credit exposure to that issuer while retaining the bond's interest rate exposure. Second, a fund manager expecting credit deterioration can buy CDS protection on an index or specific name as a speculative trade without owning the underlying bonds. Third, CDS basis analysis — comparing CDS spreads to bond credit spreads — identifies potential mispricings. Fourth, sovereign CDS (on government bonds) are used by macro traders to express views on country default risk and to hedge emerging market sovereign bond portfolios. The CDS market provides real-time, liquid signals of credit stress that often lead bond market price movements.
Key Terms:
Quiz Questions:
Q1. A credit portfolio manager holds $10M in face value of Apex Corp bonds. She is concerned about near-term earnings risk at Apex but does not want to sell the bonds due to tax and transaction cost considerations. She buys CDS protection on Apex Corp in $10M notional at a CDS spread of 200 bps per annum. Apex subsequently defaults, with an auction-determined recovery price of 40 cents on the dollar. What payment does she receive under cash settlement?
A) She receives 200 bps * $10M = $200,000. B) She receives (1 - 0.40) * $10M = $6,000,000. C) She receives $10,000,000 (full par). D) She receives nothing because she did not own the reference obligation.
Answer: B — Under cash settlement, the protection seller pays 1 minus the recovery rate times the notional amount. Recovery = 40 cents on the dollar, so LGD = 60%. Payment = (1 - 0.40) * $10M = $6,000,000. This approximately offsets the loss on her bond position (if the bonds also trade at 40 cents, her bond loss is approximately $6M). She continues to hold the bonds (which she can sell or continue to hold at the recovery price). The 200 bps annual premium is what she paid to acquire this protection — that is not the settlement amount.
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Q2. The current CDX IG 5-year CDS index spread is 80 bps and an analyst believes investment-grade credit spreads will widen significantly over the next 6 months due to expected economic deterioration. Which CDS position best implements this view?
A) Sell protection on the CDX IG index (receive the 80 bps spread), which profits if spreads tighten. B) Buy protection on the CDX IG index (pay 80 bps), which profits if credit spreads widen, causing the CDS to appreciate in value. C) Buy the underlying investment-grade bonds, which profits if spreads widen. D) Sell the CDX IG index short in the equity market.
Answer: B — CDS protection buyers are short credit risk. If the analyst expects credit quality to deteriorate and spreads to widen, buying protection (paying 80 bps) allows the analyst to profit as the mark-to-market value of the protection increases. If the CDX IG spread widens from 80 bps to 150 bps, the existing protection position (bought at 80 bps) is now worth significantly more because it can be sold to a new protection buyer who would otherwise have to pay 150 bps. Buying the underlying bonds (Option C) would lose value as spreads widen.
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Q3. A fixed income analyst observes the following for Pinnacle Corp: 5-year bond credit spread = 250 bps; 5-year Pinnacle CDS spread = 180 bps. Ignoring counterparty risk and funding considerations, which of the following best describes this situation and the arbitrage opportunity?
A) This represents a positive basis; the bond is cheaper than CDS protection. A negative basis trade — sell the bond short and sell CDS protection — is not available to most investors. B) This is a negative basis situation (bond spread > CDS spread); a negative basis trade involves buying the bond (earning 250 bps over risk-free) and simultaneously buying CDS protection (paying 180 bps), earning a net spread of 70 bps with minimal credit risk. C) A positive basis (CDS > bond) suggests the CDS market is overpriced; buy the bond and buy CDS for a riskless trade. D) The spread difference of 70 bps is too small to trade and is within normal basis range.
Answer: B — Bond spread (250 bps) > CDS spread (180 bps) defines a negative basis. A negative basis trade: buy the bond and buy CDS protection simultaneously. Net carry = bond credit spread (250 bps) - CDS protection cost (180 bps) = 70 bps, earned as a near-riskless spread because the credit risk is hedged. The position earns a spread while bearing minimal net credit risk (bond credit risk is offset by CDS protection). This trade is profitable until the basis converges to zero. Negative basis persisted significantly during the 2008-2009 financial crisis due to funding constraints.
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Q4. What happens to the value of an existing CDS protection position (long protection / short credit) if the reference entity's credit quality improves significantly and its CDS spread tightens from 300 bps to 100 bps?
A) The protection buyer's position increases in value because it now costs more to buy equivalent protection. B) The protection buyer's position decreases in value (marks to a loss) because the CDS bought at 300 bps is now only worth approximately what new protection at 100 bps would cost — the position can be sold, but only at a loss relative to the premium being paid. C) CDS positions have no mark-to-market sensitivity before default. D) The protection buyer profits from spread tightening.
Answer: B — A protection buyer (long CDS at 300 bps) profits from spread widening but loses from spread tightening. If the reference entity improves and the new market CDS spread is 100 bps, the existing protection (bought at 300 bps) is now "expensive" — the protection buyer is paying 200 bps more per year than market. To exit, the protection buyer would sell protection at 100 bps, locking in a net cost of 200 bps per year for the remaining term — a loss relative to the original cost. The mark-to-market loss on a spread tightening from 300 to 100 bps over 5 years (remaining duration) would be approximately 200 bps * 5 years * notional = 10% of notional as a loss.
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Q5. A sovereign wealth fund holds $50M of Brazilian government bonds and is concerned about near-term political instability that could lead to debt restructuring. The manager wants to hedge this risk using sovereign CDS. Which statement about sovereign CDS is most accurate?
A) Sovereign CDS are not available on emerging market government bonds. B) Brazilian sovereign CDS allow the fund to buy protection against credit events including failure to pay and restructuring/repudiation; this transfers the political/credit risk from the bond position to the CDS protection seller while the fund retains the interest rate exposure of the bonds. C) Sovereign CDS will perfectly hedge all risks in the bond position, including interest rate risk. D) Using sovereign CDS violates CFA Institute Standards because it is speculative.
Answer: B — Sovereign CDS are available for major emerging market sovereign bonds including Brazil. The protection buyer transfers credit risk (default, restructuring) to the protection seller while retaining the interest rate risk of the bond. This is the key advantage of CDS hedging versus selling the bonds — it achieves targeted credit risk reduction. The hedge is not perfect because of basis risk (differences between CDS pricing and bond spread movements), recovery rate uncertainty, and counterparty risk on the CDS seller. Using CDS for hedging legitimate portfolio risk is a standard and permissible risk management practice.
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