Research Primer: Credit Default Swaps
Anyone wanting a deeper understanding of the nature of the relationships between credit default swaps (CDS), loan CDS (LCDS) and bonds and how their behavior has changed over the recent turbulent past may want to check out a new report from FitchRatings. In the article, A Brief Review of “The Basis,” Fitch discusses some of the market forces driving credit derivative trading, and the possible impact that these can have on cash instruments.
Fitch also reviews the recent market action of some of the often-discussed credit derivatives indices, such as CDX. The paper focuses on pricing issues in general, and takes a quick look at single-name CDS versus cash instruments, examining the basis.
Finally, Fitch explores the CDS/LCDS relationship, using examples such as Goodyear and Visteon as case studies.
Fitch finds that credit derivative indices have come of age, with $22 trillion total notional (both long and short) outstanding globally as of year-end 2006.
Given their often excellent liquidity, the broad exposure provided, and the ready ability of investors to establish either a long or short credit position, the traded indices would ordinarily be expected to react rapidly and abundantly to a significant change in investor sentiment, and this certainly appears to have been the case over this turbulent period.
However, Fitch cautions, care should be taken in comparing cash market indices to derivatives indices given compositional and pricing differences.
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