CDS - long/short trade

CFA Level II Portfolio Management
#1

Hi guys,

I am confused about the following. Credit quality of company A is expected to increase whereas credit quality of company B is expected to decrease. Curriculum suggests that a long/short trade is possible buy going long CDS company A and short CDS company B. I am aware that a protection buyer will gain when credit quality declines. Still this long/short trade is not clear to me. It not “going long” supposed to mean “buying” a CDS (buy protection)?

Thank you very much for your help!!

#2

Hi Pollfre,

I have not started the derivatives section yet so I cannot speak too in-depth about this but I can share my initial reactions.

The way I always remember the CDS relationships is as follows:

  • It is pretty much the same as a traditional bond. If you go long a traditional bond, you are taking on credit risk and assuming that credit quality will increase. If you go long a CDS, you are also taking on credit risk and assuming that credit quality will increase
  • The positioning nomenclature (long/short) seems completely opposite of the actual transaction (at least to me). If you are going long a CDS, you are selling protection.
  • Once again, if you are long a CDS you are assuming that credit quality will increase. If the reference entity does not experience a “credit event”, you keep the premium and make a profit. If the reference entiy does experience a “credit event”, you must make the counterparty whole and you incur a loss.
  • Think about it just like a typical insurance company. If you sell someone protection (you are going long) on their home, you are hoping that the weather improves (similar to credit quality) so that you do not have to pay for any damages. The home owner (who is going short) pays you a monthly/annual premium to guard against damanges to their home and would recieve a payment should anything happen. Not a perfect example but hopeully it helps.

I would defer to others with more experience in this topic.

#3

I get the idea. I think the main issue here is the CDS terminology that kind of inverts the traditional interpretation of long and short.

Thanks for the feedback!

#4

It may sound confusing because we think Buy Protection = Long, Sell Protection = Short. In finance, going long means we benefit when something improves and going short - when something deteriorates. In CDS world we think the same and this _something_ means Credit Quality.

When we buy (sell) protection we actually hope that the credit quality will go down (up), so we can benefit from the trade. That means buying protection we hope credit quality will deteriorate, and selling protection - credit quality will improve.

To sum up: Buy Protection => Credit Quality to deteriorate = Short Position Sell Protection => Credit Quality to improve = Long Position