Thursday, January 27, 2011

CDS basics

Background: Many speculators trade "credit products [1]" for a quick profit. In terms of hedgers, I guess bond underwriters may keep some of the new bonds during the bond issue, in which case they would later trade these bonds as part and parcel of the investment banking (underwriting) business.

At the lowest level of the product hierarchy, the underlying product is probably a corporate bond. Since there's default risk, a common hedge is a CDS.

In fact, CDS is about the only hedge there is. You can also trade the issuer's preferred stock, commercial papers etc as these are correlated to the bond in your portfolio. I feel shorting the stock is practical only if you intend to hold the bond for a few days.

[1] corporate bonds, CDS etc

Exchanges bring bids and offers together - price discovery through the open order book. In contrast, a pure-play clearing house leaves buyer/sellers alone negotiating trade price over phone/email, but once trade executes, real money is maintained at the margin accounts in clearing house. Clearing house recalculates mark-to-market (not PnL) and margin ratio.

If a counterparty (like Lehman) collapses, clearing house acts as a shock buffer, to break the chain reaction of defaults.

Someone said CDS is like an insurance on a corporate bond.

I guess counterparties leave their security deposit in the clearing house for the duration of the CDS.

Margin risk in CDS is tricky. Scenario testing is required. Concentration risk is the most obvious risk -- if an account holds most of the securities about a particular issuer, and the issuer defaults, then no one wants to buy those securities.

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