Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives

CHAPTER 7

Credit Default Swaps and the Indexes

The synthetic markets have grown rapidly in both size and popu■ larity, and now dominate the volume of trading activity in the corporate credit markets. In this chapter, we provide an overview of single-name credit default swaps (CDS)¹⁹ and the indexes.

Credit derivatives enable the isolation and transfer of credit risk between two parties. They are bilateral financial contracts which allow credit risk to be isolated from the other risks of a financial instrument, such as interest rate risk, and passed from one party to another party. Aside from the ability to isolate credit risk, other reasons for the use of credit derivatives include:

• Asset replication/diversification

• Leverage

• Regulatory capital efficiencies

• Yield enhancement

• Hedging needs

• Liquidity

• Relative value opportunities

We begin this chapter with a brief introduction to CDS on specific corporate issuers, discussing what they are, who uses the market, and why. We then discuss the CDS indexes, and examine factors such as how they perform relative to other assets.

WHAT ARE CREDIT DEFAULT SWAPS?

The typical analogy used for CDS is an insurance contract. When you buy insurance, you are buying financial protection against a specified event. For example, a homeowner buys earthquake or flood insurance to “hedge” against a catastrophic event. CDS can be considered a policy used to “hedge” against corporate default.

That said, there are important differences between CDS ...