CDS

[higaurav]

Hi David,

I am not clear how C is the hedge, now here we need to create the synthetic returns as good as selling the corporate bond. So Buy government bond and buy CDS (as we pass on the premium for the default risk). In such a way profit is locked for Wallace. But ans C mentions to Short the CDS. Please correct my understanding, if I am not right here. Thnks.

Practice set III
Q31. Wallace, an emerging market bond trader, is holding a USD 5 year Malaysian corporate bond in his book.
He has made enough profit from this bond position and wishes to lock in the profit (full hedge) without
selling it. Which is the best option for Wallace below?
a. Buy protection with a USD 5 year Malaysian bond.
b. Buy protection with a USD credit default swap on the Malaysian corporate bond.
c. Buy protection with a USD 5 year US Treasury government bond and short a USD credit default swap
on the Malaysian corporate bond.
d. Buy protection with a USD 5 year Ringgit Malaysia government bond and USD short a credit default
swap on the Malaysian corporate bond.

Rgrds
OM

 

[skcd]

There is US treasury and Malaysian Ringgit involved here. So both credit (default) and currency risk. Hence Going Long Corp bond gives him a position where he needs to hedge both currency (which he does by buying UST so that is pure risk free (atleast in theory)) and he goes short USD CDS of the Mal corp here.

Long Corp Bond (Getting coupons on the Mal Corp bond being exchanged at USD/Ringgit)
= Hedge with Short Trsy (Malaysian) (only if he were receiving in Rngt) and Short CDS (in the sense pay premium and get paid on default) (only if he were recvng in Rngt)

1) LHS, there is risk of USD falling against Rngt, 2)Hedge that will the short CDS (so in turn you are paying and receiving in USD only). Paying the CDS coup and receving the bond coups both in USD
3) Go long USD trsy and that compensates the balance.


Thats how i think about it.

Also, it always helps to remember short CDS is long protection (gets paid on default) and long CDS is short protection (getting paid the coupons)

 

[itsyourz]

Hi,

short CDS is buying protection?

does short means selling? so CDS seller gets premium and risk from CDS buyer

that's what I know so far

but as i saw your reply then i am getting confused

am i wrong??

one more thing, why is it risky that USD depreciation against rngt,

Wallace is getting paid coupon in Rngt, though. USD depreciation is good situation isnt it?

suk

 

[David Harper CFA FRM]

skcd,

Thanks for the great help. One terminology note: if the answer is (C) as you point out, the terminology in the answer looks wrong to me. Buying protection is long the CDS instrument. In my understanding (source: Moorad Choudhry, The CDS basis):

Long CDS = buyer of protection = synthetically short the reference bond
Short CDS = seller of protection = synthetically long the reference bond

David

 

[skcd]

Sorry i might have interchanged(screwed up!), i am sure Long CDS is i am buying the CDS to protect myself against default. So i guess i confused the whole thing. I apologize.

 

[higaurav]

Thanks SKCD.

David, I get the definition correctly but in the context of the question, I do not understand that why it says that Wallace is shorting CDS and there is my disconnect to it. Pls help

Rgrds
OM

 

[David Harper CFA FRM]

I think your original instinct was fine. The question is technically incorrect to say "short the CDS." It should say "long the CDS" as I am pretty sure it means to buy credit protection. (C) is technically incorrect. David