Sunday, 13 November 2011

CDS Curve Inverts and How To Make Money?

First, intuitively, what does CDS curve inversion tell? Bloomberg gives simple illustration.

Some more elaboration from FT: US CDS curve inverts for first time ever

Some years ago, we see Spain in problem from this type of chart: Another CDS curve inverts — Spain

Now, people are seeing Italy's CDS curve inverting ... What can we do (actually what did people do a few months ago)?

FT Alphaville talks about simple "hedge" strategy (I guess one of the best explanation about these strategies I ever read):

The way to profit from a move like this would have been to buy the short end (1-year or 3-year tenors) and sell the 5-year. The bet is that the short end will move up by more than the 5-year. If you had entered into this trade by the end of June, thinking the curve would almost certainly invert (or at least flatten significantly), then the 1-year and 3-year tenors would have looked cheap as chips.


So… let’s say you bought $18m notional on Italy at the 3-year point and sold $10m notional on the 5-year. Depending on the shape of the curve at the time that you entered the trade, the carry could be positive or negative, but FT Alphaville hears that it’s positive most of the time. That’s nice.

Also, what if the name you’re trading does go belly-up and there is actually a credit event while holding these positions? After all, you’re taking a bearish bet. Thinks are hardly looking rosy in your world.

Well, not to worry, as you’ve bought more protection than you’ve sold. A credit event would actually be a positive for you. Go you, champion credit derivatives trader!


This is a great article explaining about CDS trade, including very intuitive explanation about duration, carry, bid/ask spread. Some of the comments share my view.

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