Page 22 - FINAL CFA II SLIDES JUNE 2019 DAY 10

LOS 38.d: Describe the use of CDS to manage credit
exposures and to express views regarding changes READING 38: CREDIT DEFAULT SWAPS
in shape and/or level of the credit curve.
MODULE 38.3: CDS

USES OF CDS USAGE
Earning arbitrage profits is another motivation for trading in the CDS market:

• Basis trade attempts to exploit the difference in credit spreads between bond markets and the CDS market. It hopes
mispricing will be temporary and that disparity should eventually disappear after it is recognized. For example, if a specific
bond is trading at a credit spread of 4% over LIBOR in the bond market but the CDS spread on the same bond is 3%, a
trader can profit by buying the bond and taking the protection buyer position in the CDS market. If the expected
convergence occurs, the trader will make a profit.

• Leveraged buyout (LBO), the firm issues a great amount of debt in order to repurchase all of the company’s publicly
traded equity. This additional debt will increase the CDS spread because default is now more likely. An investor who
anticipates an LBO might purchase both the stock and CDS protection, both of which will increase in value when the LBO
eventually occurs. In the case of an index CDS, the value of the index should be equal to the sum of the values of the
index components. An arbitrage transaction is possible if the credit risk of the index constituents is priced differently than
the index CDS spread.

• Collateralized debt obligations (CDO) are claims against a portfolio of debt securities. A synthetic CDO has similar
credit risk exposure to that of a cash CDO but is assembled using CDS rather than debt securities. If the synthetic CDO
can be created at a cost lower than that of the cash CDO, investors can buy the synthetic CDO and sell the cash CDO,
engaging in a profitable arbitrage.