In addition to single name credit default swaps, where there is one underlying reference entity, CDS indexes, which relate to a basket of reference entities.
Also exist Indexes are used throughout finance to describe movements in broad markets.
For example, an index like the s and p 500 describes movements in the prices of 500 shares in the US stock markets.
In CDS indexes, the measurement describes movements in the prices of a basket of single name CDS spreads.
Just like with stock indexes, a way of trading CDS indexes has been developed by turning the index into a credit index swap.
The most popular versions of credit index products are itracks and CDX.
Mechanically, these index swaps work like a basket or a collection of individual single name crater default swaps.
Just as for single name CDS, there's a protection buyer and a protection seller.
The buyer will pay a premium to the seller and receive protection on the basket of names.
On screen, you can see an example using the I Europe Index containing 125 reference entities.
If this trade is done in 125 million euros, that equates to a million euros of CDS notional on each of the 125 names.
The magnitude of the premium leg will represent the average CDS spread on these companies.
Thinking about trading motivations, one can understand that the difference between credit index swaps and single name CDS is just the scope of the underlying reference names.
Other than that, motivations to be the buyer or the seller remain the same.
For example, a seller may want to express the view that credit spreads narrow across the board, and with the credit index swap, they enjoy the convenience of expressing that view in one trade.
Equally, a buyer may be looking to put on a macro hedge of an underlying loan portfolio, which is exposed to the credit risk of a broad sector.
In the event of default, the index swap works as you would expect, the combination of individual cdss inside it to work.
The default is processed on one name and the trade carries on with the remaining surviving names in a reduced notional.
For example, if you were to buy 125 million of the IRAs Europe Index and one name defaults, you'll receive the default lake payment on 1 million euros of notional.
With the recovery on that individual Name being market implied in the usual way, the iTrack swap will then continue in a notional size of 124 million euros.
