This is particularly important for a short position, i. If the investor's horizon is extremely short, the trade may actually perform and be unwound much earlier than the high future premium payments come into effect. Of course, this amounts to an implicit increase in the leverage of the trade, which can be defined as the amount of mark-to-market risk per unit of current premium payment.

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Like most long-short or forward trades, the steepeners and flatteners can be and frequently are used for their leverage effect in conjunction with a directional view of the underlying market, rather than because of the specific level of the forward value of the underlying which is encoded in them. In the case of popular Dow Jones CDX portfolio default swaps, the leverage incentive is even more important because these products trade with fixed contract spread and variable up-front payment depending on the current portfolio spread.

Netting of these up-front payments for CDX curve trades leads to a substantial decrease of capital commitment and consequently to an increase in expected return on capital. Investors should be aware of this and should carefully differentiate the reasons for entering into curve trades in CDS. This week's Learning Curve was written by Arthur Berd , senior v. Berd, A. McAdie, R. Bhimalingam and S. Forward CDS Trades A forward CDS contract corresponds to buying or selling credit protection that is active for a period of time in the future at a premium which is preset today, but payable only during that future period.

Curve Trading Strategies The forward CDS spreads derived in this fashion can be compared with the spot CDS spreads of similar horizon and, depending on the issuer and market credit outlook, can serve as an indicator of relative value for either long or short forward trades in CDS. References Berd, A. Latest news from Derivatives Barclays, Deutsche dodge losses thanks to risk transfer market but investors tighten terms 01 Mar Meine Mediathek Hilfe Erweiterte Buchsuche.

Credit Default Swap Trading Strategies. Inhaltsangabe:Introduction: Credit default swaps are by far the most often traded credit derivatives and the credit default swap markets have seen tremendous growth over the past two decades. Put simply, a credit default swap is a tradeable contract that provides insurance against the default of a certain debtor. Initially, when the first form of a credit default swap CDS was traded in , they were mainly used by commercial banks in order to lay off credit risk to insurance companies.

However, focus shifted in the subsequent years as new players entered the market.

Measuring & Trading Forward CDS Spreads

Hedge funds became big players, money managers and reinsurers entered, and banks started to not only buy protection on their assets but also sell protection in order to diversify their portfolios. This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code.

In particular, concerns arising out of Conseco 's restructuring in led to the credit event's removal from North American high yield trades. As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled. The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations.

This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default. The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled. When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction also known as a credit-fixing event may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price. During the auction process participating dealers e.

A second stage Dutch auction is held following the publication of the initial midpoint of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association ISDA , who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington Mutual.

Below is a list of the auctions that have been held since There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the 'probability model', takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.

Under the probability model, a credit default swap is priced using a model that takes four inputs; this is similar to the rNPV risk-adjusted NPV model used in drug development :. If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract.

If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:. To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red.

If the contract is terminated the square is shown with solid shading. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time. To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give. In the "no-arbitrage" model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage.

Both analyses make simplifying assumptions such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default , which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of , and the swap spread is 70 basis points, then a CDS contract should trade at However, there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor.

The difference between the theoretical model and the actual price of a credit default swap is known as the basis. Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency.

Furthermore, there have been claims that CDSs exacerbated the global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG. In the case of Lehman Brothers, it is claimed that the widening of the bank's CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble.

Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default. Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the General Motors Chapter 11 reorganization , because certain bondholders might benefit from the credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors had an incentive to push for the company to enter bankruptcy protection.

Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman's CDS spread widened, reducing the net cashflows on the days after the auction. Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis; that CDS contracts have been acting to distribute risk just as was intended; and that it is not CDSs themselves that need further regulation but the parties who trade them. Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously described derivatives bought speculatively as "financial weapons of mass destruction.

In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen. To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one's counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection.

The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs.

Credit Default Swap Trading Strategies - Wolfgang Schöpf - Google Books

Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. During the financial crisis , counterparties became subject to a risk of default, amplified with the involvement of Lehman Brothers and AIG in a very large number of CDS transactions. This is an example of systemic risk , risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk. For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in and decided to hedge their exposure by buying CDS protection from Lehman Brothers.

After Lehman's default, this protection was no longer active, and Washington Mutual's sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. Chains of CDS transactions can arise from a practice known as "netting".

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However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C. The problem lies if one of the companies in the chain fails, creating a " domino effect " of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company.

Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B. As described above , the establishment of a central exchange or clearing house for CDS trades would help to solve the "domino effect" problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers. The U. There is a risk of having CDS recharacterized as different types of financial instruments because they resemble put options and credit guarantees.

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If a CDS is a notional principal contract, pre-default periodic and nonperiodic payments on the swap are deductible and included in ordinary income. The thrust of this criticism is that Naked CDS are indistinguishable from gambling wagers, and thus give rise in all instances to ordinary income, including to hedge fund managers on their so-called carried interests, [] and that the IRS exceeded its authority with the proposed regulations. This is evidenced by the fact that Congress confirmed that certain derivatives, including CDS, do constitute gambling when, in , to allay industry fears that they were illegal gambling, [] it exempted them from "any State or local law that prohibits or regulates gaming.

The accounting treatment of CDS used for hedging may not parallel the economic effects and instead, increase volatility.