Use of CDS to Manage Credit Exposures

The credit curve shows the credit spreads over a risk-free benchmark rate for a range of maturities of a firm’s debt. A credit spread rewards bondholders for assuming credit risk.

The shape of the CDS credit curve can be explained by the survival probability, default probability, and hazard rates.

Many CDS credit curves are upward sloping. Since the probability of default increases with longer periods, investors require greater compensation or spread for providing protection for such periods.

An upward sloping credit curve implies that companies are more likely to default with every year that passes and that the likelihood is ever-increasing each year. Credit risk is thus increasingly worse every year into the future.

The credit curve is flat for a constant hazard rate. Downward-sloping CDS curves are rare and mainly result from severe near-term financial stress.

Investors use CDS to:

• Take advantage of valuation differences between CDS and the underlying.
• Exploit expected variations in the underlying.

CDS Trading Strategies

A curve trade is a long/short trade where the investor buys and sells protection on the same borrower (reference entity) but with different maturities. Curve trades on single names seek to exploit changes in the shape of the respective CDS credit curve.

If the borrower’s short-term outlook is bullish, an investor can buy (long) protection in a long-term CDS and sell (short) protection on a short-term in a short-term CDS. This is called a curve-steepening trade.

On the other hand, if the reference entity’s short-term outlook is bearish, an investor will enter into a curve flattening trade. This means that the investor will buy a short-term CDS and sell a long-term CDS.

A naked CDS allows an investor without exposure to the reference entity to buy or sell a CDS contract

A long-short strategy involves purchasing protection on one reference entity and selling protection on another reference entity at the same time. Here, the investor believes that the credit position of one entity will improve relative to that of another.

Question

A firm’s 15-year CDS trades at a credit spread of 900 bps, and the 8-year CDS trades at a credit spread of 700 bps. If the 15-year spread widens by 300 bps while the 8-year spread remains unchanged. The most likely implication of this change in the credit curve is that the:

1. Firm’s longer-term creditworthiness is less attractive
2. Firm is riskier than before in the short term.
3. Firm’s longer-term creditworthiness has improved.

Solution

The correct answer is A.

The widening of the 15-year spread implies that the firm’s creditworthiness will deteriorate in the longer term, even if it is not any riskier in the short term.

Reading 32: Credit Default Swaps

LOS 32 (d) Describe the use of CDS to manage credit exposures and to express views regarding changes in shape and level of the credit curve.