Can anyone provide some insight into the flattening trade CDS question on the Merinar case (Derivatives - AM)? It says that they expect the reference company’s credit metrics to weaken over the next two years but improve in 5 years. Wouldn’t this call for a short (protection buyer) 2 year CDS position and a long (protection seller) 5 year CDS position?
Sorry if this is a dumb question, I am just not sure how CFA is getting the answer of long 2 year and short 5 year.
Thanks!
Here is how I understand it:
Since there is a high probability that the company will default in two years, the CDS spread will be higher. Conversely, since there is a low probability of the company default in five years, the CDS spread will be lower. This is the reason the curve is flattening. Hope I’m right…
Thanks Julia!
I thought your scenario is representative of a basis trade as opposed to the curve trade? For example, if the two year CDS spread was high compared to the underlying bond credit premium, you could buy (sell protection) the two year CDS and sell the underlying bond. Conversely, if the five year CDS spread was low compared to the underlying bond credit premium, you could sell (buy protection) on the five year CDS and buy the underlying bond.
This matches up with the answer as far as the CDS positions are concerned, I am just wondering how we were supposed to infer that it was a basis trade and that the CDS spread/underlying credit premium provided an opportunity to execute the trade?
I’m with you tgile. I was certain i had this correct until i thought about it a little more. Here’s my logic…
Credit is deteriorating, THEN improving. How can you profit?
Long position (buy) in a CDS increases in value when credit deteriorates. The whole point of buying a CDS is because you’re afraid of default (you think credit will deteriorate)…sooo…you’d go long on the 2 year (as credit goes bad), then you’re short over the longer term when you think credit will improve.
It’s very simple, just htink of it in terms of insurance.
If you buy a CDS (long a CDS) you are buying “insurance”. If the company defaults, you get paid. That’s what’s happening here, you are buying insurance in case the company defaults. Since the credit risk of the company is deteriorating (higher likelihood of default), so your CDS will go up in value as you approach 2 years.
When you short a CDS, you are selling insurance. If you sell this insurance when prospects are poor, you can sell for protection at a premium. As the credit of the company improves, you can’t sell protection for as much money. So as the company’s prosepcts improve, your CDS position gains moneys.
Another way to think of it is this:
You are believe that the credit risk is high in 2 years, so you want to purchase a CDS.
You believe that the credit risk will be low again in 5 years, so you will sell a CDS to recover your money back.