Credit Default Swap Indices
August 22, 2022
What are Credit Default Swap Indices？
As the most common credit derivative, a credit default swap (CDS) is an over-the-counter (OTC) financial contract between two parties in which one party purchases protection from the other party against losses from a specified credit event, such as a default on a debt. A CDS allows investors to regulate their own credit risk exposures.
The credit derivatives market grew nearly 16 times between 1997 and 2003, much faster than the overall derivatives market. The promise held by the credit derivatives market had attracted many participants, and some banks began to develop CDS indices as a new instrument for investors since 2003.
Credit default swap indices are baskets of single-name CDS with fixed portfolios and maturities. CDS indices are tradable and can be used for derivatives trading, allowing investors to establish long or short credit risk positions. If one of the underlying reference entities in the index defaults, the investor will receive a payment proportional to the weight of the defaulted entity in the index, and the principal value of the note will be reduced as a result of the default.
Key Learning Points
- CDS indices are typically equally weighted baskets consisting of single-name credit default swaps.
- CDS indices provide investors with liquid, standardized synthetic exposure to the corporate bonds of a specific set of companies at low transaction costs.
- Trading volumes of CDS indices have been steadily increasing over the years, and they are now the most important instruments in the fast-growing credit derivative market.
Benefits of CDS Indices
As the most liquid instruments in the fast-growing credit derivative market, CDS indices constitute the main building block for investment banks and other intermediaries in the construction of second-generation instruments. In addition, during periods of market volatility, CDS indices are often the most efficient trading instruments and are often used to gauge credit market sentiment.
The benefits of using CDS indices include:
- Tradability and Liquidity: CDS indices are easier to trade and price than a basket of cash bond indices or single-name CDS. Standardization, also bring more liquidity to the trading process.
- Low transaction Costs: The indices are cost-efficient means of trading portions of the market and are often traded at attractive bid-ask spreads.
- Efficiency: CDS indices allow investors to gain exposure to a portfolio of instruments through a single trade and are traded under standardized conditions within the framework of a Clearing House.
- Transparency: Rules, constituents, and parameters of CDS indices are all available publicly.
- Industry Support: CDS indices are supported by all major dealer banks, buy-side investment firms, and third parties.
Main Types of CDS Indices
Currently, there are two main series of corporate CDS indices: CDX and iTraxx.
- iTraxx indices are one of the most significant developments in the credit markets, resulting from the merger between two leading families of indices TRAC-X and iBOXX. iTraxx indices are highly liquid and standardized, including the most liquid and heavily traded based on European, Asian, Middle Eastern, and emerging markets credit, ensuring that the indices are replicable. The iTraxx indices allow investors to express their bullish or bearish sentiments on credit as an asset class and help portfolio managers actively manage their credit exposures.
- Another most widely used CDS indice is CDX, which covers multiple sectors including investment grade, high volatility, high yield, and emerging market and rolls semi-annually in March and September. The high liquidity and transparency of CDS indices enable investors to trade credit index tranches, options, and first-to-default baskets.
Two main types of CDS indices: iTraxx and CDX
Example
Intercontinental Exchange (ICE), a leading operator of global exchanges and clearing houses and provider of mortgage technology, data, and listings services, has offered to clear more than 500 single-name and index CDS instruments based on corporate and sovereign debt since 2009 and has reduced counterparty risk exposure by clearing over $283 trillion in two-sided notional amount.
Hence, building on the tremendous momentum across the CDS complex, ICE Clear Credit launched the clearing of index options on the CDX North American Investment Grade and High Yield indices in 2020 and index options on the iTraxx Europe indices in 2021, bringing greater capital efficiencies, price discovery and risk management to the CDS market.
Conclusion
CDS indices are benchmarked against credit default swap instruments. These indices can be used to adjust maturity and duration, as well as hedge the credit exposure of a static portfolio of reference entities. CDS indices are easy to trade, have lower transaction costs, and are more liquid than baskets of cash bond indices or single-name CDS’. Moreover, they offer greater transparency and enjoy industry support.
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MCQ – Credit Default Swap Indices
Download the Excel file for the answer.
