CDS index

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CDS index

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Credit Default Swap, Index and Index Option

Definition

A credit default swap index is an OTC[1] credit derivative used to hedge credit risk or to take a position on a basket of CDS

It tracks and measures total returns for the various segments of the bond issuer market so that the index’s overall return can be benchmarked against funds that invest in similar products.

By selling the index, the exposure of credit risk is passed on to another party. 


graph
      subgraph CDX
        CDS1(CDS1)
        CDS2(CDS2)
        ...
        CDS_N(CDS_n)
      end

Number of Names – varies a lot across indices, from 10 (Sovereign indices) to 125 names (for investment grade indices)

:green_book: Glossary

[1] OTC – Over-The-Counter – Refers to trades negotiated and conducted directly between two parties, i.e. off-exchange trading is done directly between two parties, without the supervision of an exchange. This rule contrasts with trades conducted on exchanges, where the rules of the particular define the trades
exchange

Long? Short?

:closed_book: Note: The long / short of the CDS index and the CDS are opposite!

Long Index = Index Buyer = Short CDS = Protection / CDS Seller = Long Reference
Short Index = Index Seller = Long CDS = Protection / CDS Buyer = Short Reference

Benefits

Tradability

  • A CDS index can be traded and priced easier than a basket of cash bond indices, or single name CDS
  • Investors can trade funded and unfunded credit derivatives linked to a credit benchmark

Liquidity

  • Significant liquidity is available in indices
  • Driven more liquidity in the single name market

Credit Risk

  • monitor portfolios against this benchmark and adjust their holdings accordingly
  • efficiently hedge risk against default
  • speculate about potential changes in issuers’ credit quality
  • Allow market participants to take a view on the overall credit quality and direction of the underlying basket in one tradable instrument

Participants

graph RL
Markit(Markit)
Licensed_Participants(Licensed Participants )
Institutional_Investors(Institutional Investors)
ISDA(ISDA)
Third_Parties(Third Parties)
Indices(CDS Indices)

Markit -- "Owns and operates indices" --> Indices
Markit --"Cooperate" --- ISDA
Licensed_Participants --"Cooperate" --- ISDA
Licensed_Participants -- "Trade indices; Provide liquidity" --> Indices
ISDA -- "Legal doc" --> Indices
Third_Parties -- "Provide platforms" --> Indices
Institutional_Investors -- "Hedge positions" --> Indices

Markit – An American-British information provider responsible for the licensing, marketing, administration, and calculation of CDS indices.

ISDA – International Swaps and Derivatives Association is the global trade association representing participants in the privately negotiated derivatives industry, a business covering swaps and options across all asset classes (interest rate, currency, commodity and energy, credit and equity).

Licensed Participants – Like banks & licensed Swap Execution Facilities

Third Parties – Like MarkitSERV

CDS vs CDS index

CDS CDS Index
Liquidity Less liquid More liquid
Bid-offer spread Larger Smaller (1-2 basis points*)
Cost to hedge a portfolio – More expensive;
– Need to buy many CDS to achieve a similar effect		 Cheaper

:green_book: Glossary

Basis point – 1/100th of 1%. 100 basis points = 1%.

Index Roll

  • Index Roll: to create a new index series
  • The previous index becomes off-the-run[1]
  • The new index is the new on-the-run series[2]

Frequency – Roll every six months (March & September)

New series

  • Created with updated constituents.
  • The composition of each new series / new index is established based on rules.
  • Enable the current series to track the most relevant instruments in the credit market.

Legacy series

  • Continues trading
  • Liquidity is concentrated on the on-the-run [1] series [2]

:green_book: Glossary

[1] Off-the-run / On-the-run – For indices, the new series is referred to as being on-the-run, with the previous series referred to as being off-the-run

[2] Series – Term identifies the series of a specific index and its main characteristics.

:blue_book: For example, in September 2008, Markit rolled the Markit CDX IG index to series 11. In March 2009, Markit rolled the Markit CDX IG index to series 12.

[3] Version – A version number identifies each index series. After an index rolls, the initial version will be one. A new version of the index is published to represent the removal of constituents because of credit events and early termination (for LCDX).

:blue_book: For example, Markit CDX HY 11 v1 was the version of the Markit CDX HY index launched at the roll of September 2008. After removing Tribune Company because of bankruptcy, a new version Markit CDX HY 11 v2 was published. After removing Nortel Networks Corporation, a new version was published, Markit CDX HY 11 v3.

Roll Timeline

Weighting

Each entity in CDX will have equal or approximately equal weightings.

Exceptions:
CDX Bud and CDX Latam Corp are decided by-poll

Calculation

The weighting of each entity will be equal to

$$ 1 / text{number of entities in such sub-index} $$

Expressed as a percentage with three decimal places (e.g. 3.226%)

Rounding

When rounding is necessary, the entities shall be arranged in alphabetical order.

Entities at the top – Rounded up to the nearest one-thousandth of a percent.
Entities at the bottom – Rounded down to the nearest one-thousandth of a percent.

So that the weightings of all entities have been rounded and the aggregate of the weightings equals exactly 100%.

History

Before 1980s: most of the bonds are IG (jinvestment grade)
After 1980s: start to have more HY (high yield) bonds

CDX & iTraxx

There are currently two leading families of CDS indices: CDX & iTraxx.

CDX

CDXs are made up of the most liquid entities in the relevant single-name CDS market.

The two leading families of CDX are investment grade (IG), high yield (HY).

CDX.NA.HY CDX.NA.IG
Underlying Rating High yield Investment grade
Entity number 100 125
Maturity Date Roll Date: September (March) 27

Maturity Date: December (June) 20th

 Roll Date: September (March) 20

Maturity Date: December (June) 20th
Maturity in Years 3, 5, 7 and 10 years 1, 3, 5, 7 and 10 years
Coupon (bps) 500 100
Recovery Rate (%) 30 40
Sub-Indices HY.B, HY.BB Sectors

iTraxx

  • Thomson Reuters Eikon code ‘ITRAXX’; Bloomberg code ‘ITRX’
  • Known simply as ‘The Main’.

CDX vs iTraxx

CDS Index iTraxx CDX
Region Europe
Asia
Emerging Markets		 North America
Emerging Markets
Credit Event Bankruptcy
Failure to Pay
Modified Restructuring		 Bankruptcy
Failure to Pay
Currency EUR, JPY, USD USD, EUR
Reference Entities for inclusions and exclusions A liquidity poll A rules-based approach
including liquidity, sectors and ratings
Business Days London and TARGET Settlement Day – USD: New York and London
– EUR: London and TARGET Settlement Day

TARGET Settlement Day – Days on which the Trans-European Automated Real-Time Gross Settlement Express Transfer (TARGET) System is open.

Trading indices

Quotation

Indices trade either on a spread or on price.

  • This convention mimics the cash instrument where some bonds trade on yields and others on price.
  • The CDS indices convention matches that of the underlying cash instruments.

Spread

  • CDX (IG, HVOL, LATAM Corp)
  • iTraxx (CEEMEA, Europe, Japan, Asia ex-Japan, Australia)
  • SovX
  • MCDX

Price

  • CDX (HY, EM)
  • LCDX
  • LevX

Converter: CDS Index Price to Spread

Converting the price to spread and vice versa can be achieved via

  1. The Markit Converter , or
  2. The spread can be approximated using the dollar value of 1 basis point (DV01*) and multiplying that by the difference between the deal spread and the quoted spread.

:green_book: Glossary

DV01 – aka Risky Duration – The change in the mark-to-market value of a CDS trade for a 1bp parallel shift in CDS spreads. Though Risky Duration and Risky Annuity are often used interchangeably, the two measures yield changes that are very close are only for CDS spreads trading at par. For larger spread movements away from par, this assumption becomes increasingly inaccurate.

:blue_book: For example, if an index has a fixed coupon of 60 and the current coupon is 90, it is positive for the protection buyer (they are paying 60 for something that is currently worth 90). The price is inversely related to the spread, so the index’s price at 90 is lower than the price at 60, and as the protection buyer is short the credit, a price drop is positive.

Accrual

The indices are quoted on a clean basis*, meaning that accruals are not considered for pricing purposes.

:green_book: Glossary

Basis – In finance, the basis represents the difference between two instruments. In the world of credit
derivatives, the basis may refer to the difference between the CDS and the reference obligation

Upfront fee

Upfront payments are made at initiation and close of the trade to reflect the change in the price of the index

  • Coupon payments are not at fixed intervals starting from the trade date, as the first coupon period may be a different length from the others.
  • To offset the difference between traded spread and running spread and the accrual from the first coupon period, an upfront fee is paid.

Exceptions

CDX.NA.HY and CDX.EM indices are generally quoted slightly differently.

  • In the same manner as high yield single name CDSs, they are quoted as a price.
  • i.e. the percentage of the notional that is paid as an upfront fee.

Coupon Payments

Payment

  • Paid quarterly (Like 20th of March, June, September, December etc.)
  • Fixed rates will be determined by the Administrator based on industry rates and/or industry-standard trading conventions
  • The protection seller / or buyer of the index receives this quarterly coupon

Accrue

  • Use Actual/360 (except for CDX.EM, see Markit doc for details)

Present Value

Present Value – An asset valuation method, which maps future cash flows from an asset and discounts the future cash flows by an appropriate discount rate.

The Present Value (PV) of each index constituent can be calculated using one of the two following methods:

  • A simplified model using risky duration only for each credit in the index generates a decent approximation.
    The more accurate and complex way is to use the hazard rate model for each index’s underlying components. Details of this method are available on www.cdsmodel.com

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