SB here: How does a CDS steepener/flattener work?!
hi guys,
may i please get your help on a credit default swap strategy?
how does a steepener and flattener work?
in plain language please.
i know what positions you need to take, but i don't really understand why you need to do it.
Flattener = buy short-tern CDS and sell long-term CDS. you think the credit is good, but there's short term uncertainty.
Steepener = sell short-term CDS, and buy long term CDS. you think the credit is crap, but the short-term risk is low.
I don't really understand the cash flows. Why do you take those positions in the CDSs? Why is it called a flattener and a steepener? How do the cashflows work out?
Thanks a lot! SBs for an answer I can understand... or a website that actually explains wth is going on.
If the reference entity doesn't default, the cash flows are just the coupon payments the protection buyer is paying to the protection seller, and possibly any upfront payments that were made by either side upon initiation of the contract. In general, you buy protection when you think the cds spread will widen which means default probability will increase, and you sell protection when you think cds spread will tighten. The steepener/flattener position just express those views simultaneously across different parts of the spread curve of the reference entity. For example, buying short term cds means you think short term spreads will increase, and selling long term cds means you think long term spreads will decrease, which means your overall view is that the spread curve will become flatter.
"In general, you buy protection when you think the cds spread will widen which means default probability will increase, and you sell protection when you think cds spread will tighten."
Why do you buy protection when a CDS spread is going to widen? Doesn't this mean that your payments to the Seller increase? I get that there's a chance Seller will have to pay for for the defaulting bond, but if that doesn't happen, doesn't that mean you lose bigger cash flow payments when the spread does widen?
Thanks.
Sorry I found the answer to my second post:
"After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this higher rate. Therefore over the two years the hedge fund will pay the bank 2 * 5% * $10 million = $1 million, but will receive 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000."
So I get that's how you profit on a CDS if the spread widens and you previously bought. You buy the CDS, spread widens, you sell it at a higher spread.
But with reference to my first post, with reference to a Flattener, "you think the short-term is unstable, but LT is still good". how does buying a short term CDS get you profit? if the short-term is unstable, and the spread ends up adjusting downwards, won't you make a lost on the bought CDS?
You generally monetize a CDS trade by entering into the opposite side of the trade at the new market rate, as your example says.
In the case of a steepener, you buy 3 year protection and sell 5 year protection. Let's say you pay 200bps/year for the 3 year contract and receive 300bps/year on the 5 year protection.
If the company DOESN'T default for the next 3 years, you collect 300bps and pay out 200bps. After the 3 years are up, you can either enter an off-setting transaction for the last 2 years of your 5-year swap, or continue to receive the payments but carry the credit risk. If the curve moves DURING the two years, you can also monetize your gain before the 3 years are up.
If the company DOES default in the next 3 years, your swaps off-set and you earned the spread between the two until default.
Thanks Kenny.
Ok it's pretty clear that you can profit from the spread difference and protect yourself from making a loss on the collateral with an opposite CDS trade.
I think I FINALLY figured out why the two strats are called what they are... is this right:
sorry if it was really elementary but there's nothing on google and my textbook is shit.
But I'm not sure as to why you would do this going long 5y CDS at 400 bps, and short 2y CDS at 225 bps as stated in my textbook:
1) If you speculate purely on this trade, you lose the difference in the spreads. Doesn't make sense to me.
2) If you're doing it to remove credit risk from the balance sheet, it looks like you're screwed because if the bond actually defaults, and you receive the notional, say $10m, you have to pass it off to the guy you shorted the 225 bps to originally. So you lose your $10m notional that you tried to insure. Doesn't make sense again!
The only reason I see to enter this trade is the pure speculation that your short position will decrease in value (gains here) and your long position with increase in value (gains here). If the credit curve moves in any other way... you're screwed on basis?
With a steepener/flattener, you're playing the term structure. If you're betting that the risk of a 7 Y default is lower than a 3 Y default, you can set up a transaction so that your credit delta on the 7Y is positive and the 3 Y is negative with the credit exposure being neutral for a parallel 1 bp increase or decrease in credit spreads. If you are a worrier like me, you'd just buy $X of protection for 7 years and sell $X 3 year protection so you have no downside in the event of a default, but a hedge that results in $0 P/L for a 1 bp move is going to be a cheaper (albeit riskier) way to play it.
thanks illini. sorry but I don't really understand. what is credit delta? is that d-CDS/d-CreditRisk? (google didn't hit anything) with your trade to create the 7Y positive credit delta, i'm assuming you profit on the credit-risk falling. how do you create this exposure using a CDS?
Your drawings look right to me.
On your questions: 1) That's called a negative carry; there are a lot of speculative trades that have negative carry. You'd enter the trade if you had enough confidence that you're right that you are willing to stake the difference in premiums.
Lots of hedging strategies also have negative carry but are still put in place, because they represent paying a small premium to avoid incurring a big loss.
2) I am not sure how often curve trades (like a flattener or steepener) are used to hedge BS risk, since they are usually structured that you don't have principal risk (the notional insured amount of the two swaps offset).
As an aside it's theoretically possible that you would have a downward sloping CDS curve (if you have a company that's generally sound but has a near-term maturity/liquidity event.)
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