Module 38.3 LOS 38.e: CDS Use Cases

Earning arbitrage profits is a motivation for trading in the CDS market. Differences in pricing between asset and derivative markets, or differences in pricing of different products in the market, may offer potential arbitrage profits.

A basis trade is an attempt to exploit the difference in credit spreads between bond markets and the CDS market. Basis trades rely on the idea that such 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.

Another arbitrage transaction involves buying and selling debt instruments issued by the same entity based on which instruments the CDS market suggests to be undervalued or overvalued.

In a leveraged buyout (LBO), the firm will issue 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.

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