Let's now look at hedging application of A CDS as the most obvious use of A CDS is to hedge the credit risk in a bond investment.
Here, the buyer of the CDS is a bond holder who buys a CDS referencing their bond.
To keep things simple, let's assume they have bought $10 million face value of the bond at par, and they hedge by buying protection through the CDS in a matching 10 million notional.
The CDS spread we have used here is 1% per year.
Now let's analyze the economic position of the bond holder with and without default.
If there is no default, the bond holder simply pays away 1% per year.
On the CDS being long a bond, they receive the bonds yield and therefore their net receipt will be equal to the yield minus 1%.
Note that because they have hedged the credit risk in the bond, this net income should approximate the credit risk-free rate for this maturity after all the risk has been removed.
Now, let's consider what happens if there is a default on the bond side.
The market price of the bond will now have dropped, but not to zero.
Instead, the price of the bond will be equal to the market's perception of the recovery rate.
Let's say post default, the bond is trading at 40%, in which case, given that the bond was bought at par, the bond holders loss is equal to 60% of the 10 million face value, that is $6 million.
The CDS will stop and the bond holder will receive the default leg payment.
This payment will use the market price of the bond as the recovery rate, so the CDS payout will also be 6 million, thus perfectly offsetting the loss on the bond.
We can see that in this situation, the CDS has done its job in providing insurance against loss for the bond holder.
A couple of thoughts present themselves at this point.
Firstly, why does the bond holder go to the trouble of buying a risky bond? If they are then going to hedge the risk, why not simply buy a risk-free bond? And secondly, who is likely to be the protection seller in this situation, and what is their motivation to enter into the trade? Let's deal with the buyer's motivation first.
There are a few possible explanations for the buying of a bond and buying the CDS.
Maybe the net yield result is slightly higher than the risk-free rate and therefore represents an investment opportunity.
Corporate bond yields and CDS prices don't move in lockstep, so they may from time to time be pricing opportunities Present.
Also, since the CDS is a derivative contract, it can be used as a flexible hedge.
Maybe the buyer just wants to hedge half of the default risk.
That is they trade the CDS in a notional equal to half the face value, or maybe it is not default risk they want to hedge, but changes in credit spreads.
They may buy the CDS in anticipation of credit spreads temporarily increasing a situation where the bond price will drop, but the CDS hedge will make them money.
They could then remove the CDS hedge re exposing themselves to credit spreads at the now higher level.
The last example is similar to the way fund managers temporarily hedge an equity portfolio using futures.
There could also be various motivations for the seller.
Maybe they are a speculator who thinks that the premium is overstating the risk of default and therefore represents good value or who is looking to express a view that credit spreads tighten and finds the derivative trade a neater way of expressing that compared to buying a corporate bond.
The seller may of course also be a market maker who will be looking to both buy and sell CDS with their clients.
