Credit Default Swaps (CDS) and Credit Derivatives › Uses of Credit Default Swaps
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CDS contracts serve three primary purposes in financial markets: hedging credit exposure, taking speculative positions, and arbitrage strategies.
Hedging Credit Risk
A bank holding a large loan to a corporate borrower can purchase CDS protection to reduce its credit exposure. If the borrower defaults, the bank collects on the CDS to offset its loan losses. This allows banks to manage concentration risk in their loan portfolios without selling the underlying loans, which may be relationship-sensitive.
Consider a bank with a \750,000 annually for insurance. If the company defaults with 40% recovery, the bank receives \30 million loss on the loan.
Speculation on Credit Quality
Investors can use CDS to express views on credit quality without owning bonds. A hedge fund believing a company's credit will deteriorate can buy protection, profiting if spreads widen. Conversely, selling protection is equivalent to going long credit risk and collecting premium income.
This speculative use proved controversial during the European sovereign debt crisis when CDS on Greek, Italian, and Spanish sovereign debt became focal points of market stress. Critics argued that speculative CDS buying amplified the crisis, while defenders noted that CDS spreads provided valuable price discovery about sovereign credit risk.
Basis Trades and Arbitrage
The CDS-bond basis is the difference between the CDS spread and the asset swap spread on the underlying bond:
where:
- : CDS-bond basis (typically in basis points)
- : market spread for the CDS contract
- : spread above floating rate earned by swapping the bond
In theory, these should be equal through arbitrage. If the CDS spread is lower than the bond spread (negative basis), you can buy the bond, pay floating through an asset swap, and buy CDS protection, earning the spread difference with minimal credit risk. Basis trades were popular before 2008 but proved dangerous during the crisis when liquidity dried up.
# Example: Evaluating a basis trade opportunity
bond_yield = 0.065 # 6.5% yield
swap_rate = 0.045 # 4.5% swap rate
cds_spread_bps = 250 # 250 bps
# Asset swap spread approximation
asset_swap_spread = bond_yield - swap_rate
asset_swap_spread_bps = asset_swap_spread * 10000
# CDS-bond basis
basis_bps = cds_spread_bps - asset_swap_spread_bps
# Determine trade strategy
if basis_bps > 0:
basis_type = "Positive basis: CDS is expensive relative to bonds"
trade = "Sell bond + receive floating (asset swap) + sell CDS protection"
else:
basis_type = "Negative basis: CDS is cheap relative to bonds"
trade = "Buy bond + pay floating (asset swap) + buy CDS protection"CDS-Bond Basis Analysis ---------------------------------------- Bond yield: 6.50% Swap rate: 4.50% Asset swap spread: 200 bps CDS spread: 250 bps CDS-bond basis: 50 bps Positive basis: CDS is expensive relative to bonds Trade: Sell bond + receive floating (asset swap) + sell CDS protection
The positive basis indicates that the CDS acts as the more expensive instrument compared to the cash bond. The identified trade capitalizes on this by selling the expensive protection and hedging with the cheaper bond position.
