The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CHAPTER 23

Credit Default Swaps and the Indexes

Stephen J. Antczak, CFA Head of US Credit Strategy Societe Generale

 

Douglas J. Lucas Managing Director, Global Research Moody’s Investors Service

 

Frank J. Fabozzi, Ph.D., CFA, CPA Professor in the Practice of Finance Yale School of Management

 

 

 

 

 

The synthetic markets have grown rapidly in both size and popularity, and now often 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) 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 inherent in 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

The most commonly used credit derivatives employed by bond portfolio managers are single-name credit default swaps and credit default swap indexes. We will discuss these credit derivative products and their applications.