Unwind CDS - benefit to seller
So there are two ways to monetize a CDS trade:
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Opposite trade: buy a CDS then, if the market moves, sell it at a higher spread , so you pay the original spread but make money on the new (higher) spread.
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Unwind: If the market moves and the spread goes higher, the seller of the CDS buys back what he sold by paying the payments that he would receive if the buyer originally bought it at the new rate. Lets say the original spread is 100bp and now its 200bp, the original seller will pay the difference in the spread to buy back what he sold instead of the original buyer taking an opposite trade. ( its a bit more complicated than that, but thats the basic idea as i understand it)
I dont understand the benefit to the original seller in a CDS unwind. He is hoping that he can resell the CDS and receive higher payments, and hopes that the market doesnt move against him before he sells it? What if the market does move against him, how does he hedge against that?
Disclaimer: I have never traded CDS.
I'm thinking that they are generally synonymous. In the first one, you are just writing a new CDS on the underlying to collect your profit. In the other, you are closing out with the original seller (i.e. selling it back to them) and dissolving the contract. (I'm a little confused because in the opposite trade you say "sell the CDS" but when you say "pay the original spread but make money on the new spread" that tells me that you WROTE a new CDS, not sold the original).
Counterparty risk (as seen with AIG) can play a large role in CDS, so you may want to assure you close out with your counterparty in the present day as opposed to write an offsetting CDS and leaving yourself exposed to a potential default from the original counterparty.
Also, maybe not everyone who can buy can write (as is the case with options).
That's my educated guess, but as I said, I don't trade CDS and though I know what they are, I'm not an expert on their minutiae.
Typically most CDSs these days trade upfront under SNAC convention- with either a 100 bp credit spread or 500 bp credit spread, and the CDSs are transferable as well.
Markit- the firm that's in a lot of the trade confirmations- has come out with a service called "compression" that it performs for the major B/Ds. If Firm A has a CDS with firm B and Firm B has a CDS with Firm C, there's no reason for Firm B to be involved here- they're just taking on- and adding- counterparty risk. So once a week, the firms will go into Markit with trades they want compressed, and Markit will reroute the counterparties and tell you who your new counterparty is. They will also convert your trade into a SNAC, IIRC.
So the main incentive for unwinding a trade is getting out of a losing position without increasing your own counterparty risk with some third party, or because a third party firm is also reducing your counterparty risk with them in the compression process where everybody wins.
I thought the point of the firm B selling to C after buying from A was to make a profit if the spread goes up. ie: B buys at 100bp, market moves to 250bp, B sells to C and makes 150bp on payments after it pays A. Am I misunderstanding this or does B still make a profit with Markit?
B still makes the profit. What happens is B buys at 100 bp on a 5 year contract. Market moves to 250. B decides to unwind contract and calls up A, his B/D. A comes back with a bid of 247 bps for the contract (has to make a spread)
A and B now have offset the contracts, and B pays A the value of the future cashflows discounted by LIBOR+ the market spread.
In reality, what will happen is to open positions after ~2009, B will call up and ask for the credit spread on a SNAC100 contract on Firm X Senior No Re. B/D will quote a narrower spread between the bid and ask (more liquid market), and B will pay the libor-discounted difference between the credit spread and the SNAC CDS upfront. Now B only owes 25 bp every quarter to fulfill the firm's obligations under the CDS, and B/D can offset the trade with another firm, and do a compression reassignment of counterparties with Markit so it's no longer in the picture.
Doesn't A pay B the PV of the future cashflows since B was holding it as the market moved up? What you described is an unwind. So your saying taking the oppisite trade no longer takes place as Markit forces to unwind?
Ack, you're right. B pays A.
Markit and SNAC means that your position stays the same- they won't force you to unwind, but if you have two offsetting positions with two different counterparties, you can sometimes get Markit to take the counterparty risk off your hands.
In the old days, the only way to get out of a CDS position completely, eliminating counterparty risk, was to call up your counterparty to the original deal and see if he wants out.
So does B pay A like Illini said in the last response or does A pay B the PV of the future cashflows like TabThe pointed out before that?
But now with SNACs, if I'm a participant in either Markit's compression process or exchange clearing of SNAC CDSs, I can trade with another counterparty and potentially offset it without increasing my counterparty risk.
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