Introduction:
Credit default swaps are by far the most often traded credit derivatives and the credit default swap markets have seen tremendous growth over the past two decades. Put simply, a credit default swap is a tradeable contract that provides insurance against the default of a certain debtor.
Initially, when the first form of a credit default swap (CDS) was traded in 1991, they were mainly used by commercial banks in order to lay off credit risk to insurance companies. However, focus shifted in the subsequent years as new players entered the market. Hedge funds became big players, money managers and reinsurers entered, and banks started to not only buy protection on their assets but also sell protection in order to diversify their portfolios. All this led to today's CDS market being dominated by investors rather than banks and, as a consequence, CDSs are now structured to meet investors' needs instead of those of the banks.
Over the same time as this shift to an investor orientated market took place, CDS markets grew at an astonishing rate with notional amount outstanding pretty much doubling every year until peaking in the second half of 2007 at USD 62,173.20 billions. The need to effciently transfer credit risk as well as the increasing standardization of CDS contracts by the International Swaps and Derivatives Association propelled this development. Only in 2008 did the notional amount outstanding in CDSs retract for the first time and come down to USD 31,223.10 billion in the first half of 2009. A partial reason was the full blown financial crisis in which CDSs also played a prominent role.
The demise of Lehman Brothers, for example, triggered roughly USD 400 billion in protection payments and American International Group needed to be bailed out in 2008 because it had sold too much CDS protection. Amongst other concerns, these incidents highlight the systemic importance of CDSs. Combined with the phenomenal growth of CDS markets, this makes CDSs a highly relevant component of the current financial environment and a fruitful subject for academic research.
Today, just like most other financial instruments, CDSs serve a multitude of purposes spanning hedging, speculation, and arbitrage. The aim of this thesis is to explore these uses further and answer the following research questions:
What CDS trading strategies are commonly used and how does a selection of these strategies - CDS curve trades including forward CDSs, and CDS basis trades - work in detail?
To answer these questions, the thesis is structured as follows: Chapter 2 gives an introduction to CDSs. It explains how CDSs work, what their specific characteristics are and discusses important legal considerations. CDS markets are described and the main uses of CDSs are introduced in more detail. Finally, the basic structure of forward CDSs is also introduced.
Chapter 3 then proceeds to present the valuation of CDSs. The risk neutral pricing framework in which valuation takes place is shortly touched upon. Default probabilities or, in other words, the likelihood that a debtor will not honor its commitments are explained. Various credit models are introduced and, based on all this, the actual pricing of CDSs, forward starting CDSs, and their marking-to-market is explained.
Whereas the first two chapters lay out the theoretical foundation, the remaining chapters cover the trading strategies themselves. Chapter 4 is about CDS curve trades. The CDS curve, similarly to the term structure of interest rates, gives the price of CDS protection as a function of maturity. Therefore, any trade that is intentionally exposed to changes in the CDS curve shape, falls into this category. This chapter discusses benefits and caveats of trading the curve. Determinants of the curve shape and a model to get a view on possible curve changes are explained. Once one has a view about how the curve will likely change, flatteners, steepeners, butterflies or forward CDSs can be used to profit from that view. Since each of these trades requires multiple CDS positions, various schemes for weighting these positions relative to each other are then explored. Lastly, profit and loss drivers for curve trades are analyzed.
Following CDS curve trades, Chapter 5 is all about trading the CDS basis. Loosely defined, the CDS basis is the difference between the price of credit in the CDS markets as measured by the CDS spread and the price of credit in the cash markets as measured by the asset swap spread or the Z-spread. Through arbitrage, the price of credit should be the same in the two markets and the basis be zero if it were not for a variety of technical and fundamental factors that cause the basis to generally be non-zero. These factors are explained and, following that, the chapter lines out how to trade the basis, what the profit and loss drivers for basis trades are, how to choose the weights, and, finally, what the associated risks are.
The purpose of Chapter 6 is to give an outlook to other CDS trading strategies that are frequently used and to serve as a starting point for further study. One included strategy is capital structure arbitrage which tries to profit from mispricings between a company's debt and equity. Another strategy is trading CDSs versus equity puts which tries to profit from different payoffs in case of default. Lastly, there is convertible bond arbitrage which has the purpose of gaining cheap exposure to at least one of the underlying risk factors of a convertible bond - credit risk, interest rate risk or equity risk - by hedging the others.
Finally, Chapter 7 summarizes and concludes.
