reading Schweser Book 5 on Derivatives about Curve Trades with CDSs. The book says that while constructing credit curve steepener trades investors can either match notional principles of the opposing positions (thereby taking a position on duration) or match durations to manage the risk of these trades (thereby taking a position on default risk).
To be honest I am unclear what this phrase means.
Could anyone please help me to clarify what exactly means to have a position on duration or position on default risk within the context mentioned in this book ?
Haven’t done this reading yet, but I think I get the gist of it.
If I’m take a Curve Steepeing position then I’m going to short the 10y and go long the 2y. Then it comes down to how much notional principle I need on each positions. So if I short 10mm in notional prin on the 10y and long10mm on the 2y then the change in the two values is going to based on the greater duration of the 10y. So if I want to negate the effects of duration I would need a significantly larger notional principle on my 2y position than on my 10y position. So I’d need to figure out how to weight each position to avoid duration and just capture changes in Default risk.
CDS is affected by duration too. Ie the value of longer dated CDS contract (eg 10yrs) will be more affected by a 1 basis point move in the curve, than a shorter dated contract (5yrs).
So if you buy/sell the same amount of each, you’re making a bet on the duration. If you weight your investments in each so that the duration offsets each other, you’re just making a bet on whether/when the company will default.