With the 'Whale' and his fellow marine mammals leaving J.P. Morgan I thought it was high time that I put out Part II of Credit Default Swaps for Dummies. In Credit Default Swaps for Dummies - Part I we focused on the basics of how a single name CDS works. This part will focus on Index Credit Default Swaps.
First lets take a step back and look at an analogous situation in stocks. Say you have a large portfolio of stocks for which you want to hedge out the risk. Perhaps there is an upcoming event which could cause the stock market to fall so you temporarily want out of the market. Or perhaps you think you are able to pick stocks which can outperform the market - so you want to be able to go long your portfolio of stocks and short the market. Either way you want to be able to take a short position in the stock market. One way to protect against the temporary event risk might be to get out of your whole portfolio and then buy it back after the event - but that could be very expensive. Another way would be to buy put options on the individual stocks in your portfolio but that would also be expensive and expose you to other risks. You could try to short a representative basket of stocks but that is also potentially very expensive. A much simpler way would be to take a short position in futures on an index (S&P500 or Nasdaq 100 or DJIA). Assume you choose to take a short position in one S&P500 future (CME SP). This contract settles to 250 USD times the value of the S&P500 index at some later preset date. Since you are short the futures, for every one point the S&P500 index falls you would make 250 USD on your futures and for every one point the S&P500 index rises you would lose 250 USD. Hopefully the stocks in your portfolio would be closely enough correlated to the S&P500 futures to hedge out most of the risk that you are concerned about.
A similar situation can exist in the credit markets. You hold a portfolio of $100MM of credit obligations (bonds or debt) and you want to hedge out the default risk either on a permanent or temporary basis. You could try to short the debt of each of the names in your portfolio but debt markets tend to be very thin so that may not be doable - and even if it were it may be very expensive to do. You could buy single name CDS protection on each of the names in your portfolio and that would work but it could be very expensive since you would need to negotiate each one separately. What you would really like is a instrument that protects you from the default risk of a representative basket of credit names (like S&P500 futures do for stocks) and with luck you can find a basket that is closely correlated with your portfolio. Enter the index CDS!
Once again you head off to your local CDS dealer and see about taking a short position in the credit (or selling the index) using an index CDS. In this case "selling the index" is equivalent to buying default protection which is what you want to do to protect your portfolio. In the single name CDS world the terms of each CDS are negotiated individually with the dealer - but in the index CDS world there are standardized products. Say you think your portfolio is closely correlated with the CDX.NA.IG. This is an index of 125 North American (NA) investment grade (IG) credit names. Each name makes up 1/125=0.8% of the index. So buying protection on 100MM USD of the CDX.NA.IG is equivalent to buying protection on 0.8%*100MM USD = 800K USD of each of the 125 names. Each name in the index is assigned a reference asset which is generally an issue of their senior debt. There is a new version of CDS.NA.IG every six months. The names in the index will change slightly every six months. In general you choose the most recent vintage but you could choose an older vintage if it is more correlated with your portfolio than the on the run vintage. You will also need to pick a term. You can buy the standardized CDX.NA.IG for either a 5.25 year term or a 10.25 year term. Say we choose the newest vintage for 5.25 years.
As the seller of the index - or buyer of default protection - you pay the CDS dealer a fixed coupon on a quarterly basis (Mar 20, Jun 20, Sep 20, Dec 20) for each of the next 5.25 years. Say the fixed coupon coupon is 40bps annually then you would pay 0.40%*100MM USD = 400K USD annually or 100K USD per quarter. In order to keep the products standardized each index CDS has a preset coupon - in our case 40bps annually. However as conditions change the risk on the basket may increase or decrease such that the fixed coupon gets out of line with the market's perception of the risk on the basket. Hence in most cases you will either pay or receive an initial up front payment to/from the dealer to make up the difference. We are marking the index CDS to market at the outset.
Now what happens in the case of a credit event? For North American indices including CDX.NA.IG credit events are defined as bankruptcy or failure to pay. European products also include restructurings as credit events. ISDA is the adjudicator who decides when a credit event has occurred. If they decide a credit event has occurred for a particular name in your index then an auction of the name's reference asset will occur. The auction is supervised by Markit and Creditex. The price that the reference asset sells for at the auction will be denoted as the RecoveryPrice. Let us assume the reference asset of the defaulting name sells for 0.70 USD on the dollar at the auction. Following the auction you would receive a payment of 800K USD * (1-RecoveryPrice)=800K USD (1-0.70)=240K USD. Since one of the names in the index has defaulted the index will now need to be rebalanced. Going forward your CDX.NA.IG will now have a notional value of (124/125)*100MM USD = 99.2MM USD and you will pay a coupon of 0.40% * 99.2MM USD=396,800 USD per year or 99,200 USD per quarter. This will continue on until the 5.25 year term expires or until you close out your index CDS position.
This is the basic idea of an index CDS. There are many different indices and most behave similarly. Since there is a new basket for each index every six months there are many vintages of each in existance at a time each denoted by a series. Here is a quote page from Markit.
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