Reading 65: Using Credit Derivatives to Enhance Return and M

In a curve trade, an investor has different opinions about the long term versus short term prospects for a bond issuer. The trade can be a flattener or a steepener. In a credit curve steepener, the investor believes that the issuer has the ability to subsist in the short term, but that its long-term prospects are poor. The sale of the short-term credit default swap partially finances the purchase of the long-term credit default swap.

In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is a first-to-default swap, where the number of credit default swaps in the basket is typically five. In this structure, the investor would provide protection for the first (and only the first) default. If one of the reference obligations defaults, the investor owes the basket’s notional amount and receives the defaulted reference obligation. The name “correlation trade” comes about because the pricing of the basket default swap depends on the default correlation, which is the probability that two of the reference obligations in a basket will default concurrently. Higher default correlations result in lower premiums (the protection offered by the first-to-default basket is worth less to the protection buyer when it is likely that several of the obligations will default at the same time).

In one type of correlation trade, the investor sells protection on a basket of credit default swaps. One such basket is a first-to-default swap, where the number of credit default swaps in the basket is typically five. In this structure, the investor would provide protection for the first (and only the first) default. If one of the reference obligations defaults, the investor owes the basket’s notional amount and receives the defaulted reference obligation. The pricing of the basket default swap depends on the default correlation, which is the probability that two of the reference obligations in a basket will default concurrently. Higher default correlations result in lower premiums (the protection offered by the first-to-default basket is worth less to the protection buyer when it is likely that several of the obligations will default at the same time). The higher the number of credit default swaps in the basket, the higher the basket’s premium (there is a greater probability of one of them defaulting).

Options on credit indices are more liquid than single issuer options. In a receiver option, the option buyer has the right to sell a credit default swap (go long the underlying) at some future date. In a payer option, the option buyer has the right to buy a credit default swap (short the underlying) at some future date. These options will change in value as the value of the underlying changes. They can be used to provide leverage, hedge, take a position in volatility, or to create straddles and other option strategies.