Understanding Credit Default Swap Indices
In this series of posts we will have a look at credit default options which reference CDS indices. However, to get there we need to make sure we understand the underlying indices.
Definition
Credit default swaps have been around in some shape or form since the mid-1990s. Lets start with a somewhat formal definition.
“A credit default swap is a bilateral contract in which a seller of protection receives a fixed premium in return for agreeing to pay a contingent floating payment to the protection buyer if a reference entity suffers a credit event.”
You can find an introduction to default swaps at this link
It is possible to trade both single name structures (e.g. Vodafone is the sole ‘reference entity’) or portfolios of CDS. We refer to this type of structure as an index CDS. So the iTraxx Europe ‘main’ is an investment grade CDS structure that references 125 equally weighted single name default swaps. So a buyer of protection is protected against defaults in the underlying portfolio.
IHS Market, which is part of S&P Global, adminsters the indices.
These CDS indices trade with maturities of 3, 5, 7 and 10 years and a contract notional of EUR25m would not be uncommon.
The index roll
Every 6 months (March and September), the index administers publish a new version of the index which becomes available to trade. The new constituents are based on a dealer poll and are based on the most liquid names. At the time of writing the latest iTraxx Europe is series 42, published in September 2024.
Suppose I bought 5 year protection on series 41 in March 2024. When a new index is published it is common practice for market participants to ‘roll’ their exposures into a new maturity. Most dealers will be happy to quote a ‘roll price’ whereby a trader would simultaneously sell protection on series 41 (this neutralises my original exposure) and buy protection on series 42.
Credit events
So what type of so-called credit events apply to a CDS index? For the sake of brevity they would include:
- Bankruptcy: where the reference entity is dissolved, becomes insolvent or is unable to pay its debts
- Failure to pay: Perhaps a missed interest payment on a bond or a loan. Forgetting to pay the electricity bill does not count.
- Restructuring: although different variants exist, this relates to a situation where the terms of the reference entity’s debt are changed in an unfavourable manner. (US CDS tend not to include a restructuring clause).
Credit event settlement
So what happens if one of the reference entities did experience a credit event? For a single name structure, the deal will automatically terminate, and the seller would be required to pay to the buyer a contingent sum. This would be the notional amount less an agreed recovery value. This recovery value would be determined through an organised auction process (another story for another day).
The process for an index structure is a little different. Let us suppose that in the auction process the eligible assets of the defaulted name are judged to have a 40% recovery value. Since the index is equally weighted the defaulted name only makes up 0.8% of the index and so on a €25m trade the settlement amount is:
(€25m x 0.8%) * (100% – 40%) = €200,000 * 60% = €120,000
The structure continues to trade but is renamed “version 2” and the defaulted name is removed. The notional amount of any existing trade is then written down by the proportion contributed by the defaulted name. In this case it would fall from €25m to €24,800,000. The trade would continue until its scheduled maturity or until all the names have suffered a default.