Hi to everybody,
I am really confused about the CDS proper terminology. In the section relative to hedge fund strategies (Event driven) we can read in the curriculum:
“ When the acquiring company’s credit is superior to the target company’s credit, trades may be implemented using credit default swaps (CDS). In this case, protection would be sold (i.e., shorting the CDS) on the target company to benefit from its improved credit quality (and decline in price of protection and the CDS) once a merger is completed. If the pricing is sufficiently cheap, buying protection (i.e., going long the CDS) on the target may also be used as a partial hedge against a merger deal failing.”
I don’t get it. I read that when we buy protection we go short the CDS. So if the credit situation of the target improves we should sell the protection (ok for that) but we should buy the CDS. No?
Since CDS price is: (fixe coupon-CDS spread) * effective spread duration* CDS notional then the spread would narrow if credit improve and the price of the CDS should increase (ceteris paribus) ? Am I wrong?
Maybe it helps to think of it as an insurance, when you buy the CDS you buy protection and you’ll pay the Fixed coupon rate for that (don’t forget that) per annum.
Indeed if the credit spread widens the price will go down (and sell at a discount most likely) —> meaning you’ll receive an upfront premium if you would buy the CDS, but at the same time you’ll pay a coupon every year to the seller.
Last thing- when you mention ‘when we buy protection we go short the CDS’ - I would phrase it as being short the credit risk on the company (where you bought the CDS for) as you’ll still be long the CDS product. Hope this helps
Thank you. But I am still confused.
Consider this sentence extract from finquiz notes:
“ Credit-curve Steepening Trade:
The investor believes that long-term credit
risk will increase relative to short-term credit
It involves taking a short position in a long-
**term CDS and a long position in a short-term **
If we buy protection we earn because the spread widen that if the price of the CDS decrease Since CDS price is: (fixe coupon-CDS spread) * effective spread duration* CDS notional
Which implies that:
Buying protection would mean taking a short position in the CDS since it’s price will decrease because of credit spread widening.
Not sure though
When you buy protection you do not go short CDS, you go long CDS but the underlying exposure is short since you benefits from spreads widening (you benefit from a company’s worsening prospects). In general, when you short you expect things to go badly. In the case of a CDS, when you buy protection you expect things to go badly so you are short credit risk. Hopefully this makes sense but you are right, terminology is upside down for CDS which is unfortunate as it makes it more complicated.