Page 21 - FINAL CFA II SLIDES JUNE 2019 DAY 10

LOS 38.c: Explain the principles underlying, and
factors that influence, the market’s pricing of CDS. READING 37: CREDIT ANALYSIS MODELS

READING 38: CREDIT DEFAULT SWAPS

VALUATION AFTER INCEPTION OF CDS
At inception, the CDS spread (and the upfront premium) is computed based on the credit quality of the reference entity. This may
subsequently alter, leading to the underlying CDS having a nonzero value. The resulting change in value of a CDS after inception is
approximated as:
Protection buyer is short credit risk and hence
benefits when credit spreads widen.
profit for protection buyer ≈ change in spread × duration × notional principal

The buyer (or seller) can unwind an existing CDS
or
exposure (prior to expiration or default) by
monetising the gain.
profit for protection buyer (%) ≈ change in spread (%) × duration
Entering an offsetting transaction (to lock in upfront
LOS 38.d: Describe the use of CDS to manage credit exposures and to premium paid – payment received).
express views regarding changes in shape and/or level of the credit curve.

The relationship between credit spreads for different bonds issued by an entity, and the bonds’ maturities.
• If longer maturity bonds have higher credit spreads than shorter ones, the credit curve will be upward sloping.
• However, if the hazard rate is constant, the credit curve will be flat.

In anticipation of:
• increasing credit spreads, a portfolio manager may decrease credit exposure by being a protection buyer;
• declining credit spreads, a portfolio manager may decrease credit exposure by being a protection seller.

• Naked CDS, an investor with no underlying exposure purchases protection in the CDS market.
• Long/short trade, an investor purchases protection (long) on one reference entity while simultaneously selling protection
(short) on another (often related) reference entity (hopes difference in credit spreads will change to the investor’s advantage).
• Curve trade, a long/short trade where the investor is buying and selling protection on the same reference entity but with a
different maturity. If the investor expects that an upward-sloping credit curve on a specific corporate issuer will flatten, she may
take the position of protection buyer in a short maturity CDS and the position of protection seller in a long maturity CDS.