Credit default swaps positions

Credit default swap positions may be compared to bond positions when examining relative value of between the cash markets and the derivative markets. It is most common to compare the CDS with the bond on one of the following bases ... 

An example would be that a protection buyer holding a fixed-rate risky bond and wishes to hedge the credit risk of this position via a credit default swap. However, by means of an asset swap the protection seller (e.g., a bank) will agree to pay the protection buyer LIBOR +/-spread in return for the cash flows of the risky bond. In this way the protection buyer (investor) may be able to explicitly finance the credit default swap premium from the asset swap spread income if there is a negative basis between them. If the asset swap was terminated, it is common for the buyer of the asset swap package to take the unwind cost of the interest rate swap. 

Recovery rates on bonds vary by the position in the reference entity s capital structure and the level of security offered to the bond holders. Determining the appropriate recovery rate is not a trivial process and requires careful analysis into the traded prices of deliverable obligations for the reference credit. In practice there is limited historical information on the recovery rates experienced for credit default swaps. 

The credit curves (or default swap curves) reflect the term structure of spreads by maturity (or tenor) in the credit default swap markets. The shape of the credit curves are influenced by the demand and supply for credit protection in the credit default swaps market and reflect the credit quality of the reference entities (both specific and systematic risk). The changing levels of credit curves provide traders and arbitragers with the opportunity to measure relative value and establish credit positions. 

Assume the reference entity also has an issued bond (which we can assume is eligible for delivery under the credit default swap contract). However, if the asset swap level of this bond is LIBOR plus 55 bps p.a. and an investor funds at LIBOR plus 5 bps p.a., the investor in the bond would pick up 50 bps p.a. holding the bond. However, this return would be less than the credit default swap premium on the same bond. The investor could generate more value from this positive basis, then asset swapping and holding the bond. 

If an investor s funding cost is above LIBOR, then selling protection would appear more attractive than carrying a cash position and experiencing a reduced carry on the bond returns due to the funding cost. Many players in the credit default swap markets fund above LIBOR and it would seem that selling protection may cause default swap spreads to narrow. 

To reduce their credit exposure. By buying credit default swaps, banks can reduce their credit exposure on individual assets or sector concentrations. This tactic is especially useful when the positions in question cannot be sold because of relationship or tax issues. 

The most prominent impediment to swap market liquidity is swap counterparty credit exposure, which is balance-sheet intensive, in that it is a bilateral contract. The risk is the potential loss to a counterparty of the present value of a swap position if a swap party defaults. Therefore, parties to a swap transaction must be confident in the credit quality of... 

The default risk component of a swap spread will be smaller than for a comparable bond credit spread. The reasons are straightforward. First, since only net interest payments are exchanged rather than both principal and coupon interest payments, the total cash flow at risk is lower. Second, the probability of default depends jointly on the probability of the counterparty defaulting and whether or not the swap has a positive value. See John C. Hull, Introduction to Futures and Options Markets, Third Edition (Upper Saddle River, NJ Prentice Hall, 1998). 

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