CDS Indices

While a single-name Credit Default Swap transfers the credit risk of one company, a CDS index applies the same principle to a standardized portfolio of companies.

Through a single transaction, an investor can buy or sell protection on an entire segment of the credit market.

Well-known examples include:

• CDX.NA.IG — 125 North American investment-grade companies;
• iTraxx Europe — 125 European investment-grade companies.

The companies are not selected randomly. The index administrator applies predefined rules that consider factors such as credit rating, region, sector representation, and CDS trading liquidity.

Suppose an investor wants USD 800,000 of protection on each company included in the index.

The total protected notional would be:

USD 800,000 × 125 = USD 100 million

At a spread of 66 basis points, the protection buyer pays 0.66% of the notional each year.

The annual protection premium would therefore be:

USD 100 million × 0.66% = USD 660,000

Instead of entering into 125 separate CDS contracts, the investor uses one standardized index transaction.

What Happens When One Company Defaults?

Suppose one company included in the index defaults and its recovery rate is 40%.

The loss on that company would be:

USD 800,000 × (1 − 40%) = USD 480,000

The protection seller would therefore pay USD 480,000 to the protection buyer.

The constituent companies of a CDS index are organized into separate series. A defaulted company is not immediately replaced in the existing series.

After settlement, that index series continues with 124 active companies, while its remaining notional falls to 99.2% of the original amount.

Measure	Before default	After one default
Number of active companies	125	124
Notional per company	USD 800,000	USD 800,000
Remaining index notional	USD 100,000,000	USD 99,200,000
Index factor	100.0%	99.2%
Annual premium at 66 bps	USD 660,000	USD 654,720
Default settlement	—	USD 480,000

When Is the Company Replaced?

CDX.NA.IG is renewed twice a year, in March and September.

At each index roll, a new series is created with an updated portfolio of 125 companies. Some companies remain in the index, some are removed, and new companies may be added.

The old series does not disappear. It continues to exist as an off-the-run series, although most market liquidity normally moves to the latest on-the-run series.

Each series is typically created with a maturity of approximately five years. However, the newest series is generally more attractive for trading because its list of companies is refreshed according to eligibility and liquidity criteria.

How Is the Index Spread Published?

The chart below shows the index spread in basis points.

It allows the reader to estimate the annual protection premium and to observe how the market values the cost of credit protection. A higher spread generally indicates that the market expects greater credit risk or a higher probability of default.

Chart source:

https://cbonds.com/indexes/204395

How Can Mark-to-Market Performance Be Observed?

A mark-to-market chart shows how the value of an existing CDS position changes as market spreads move.

For example, suppose an investor enters into CDS protection at a relatively low spread. If market spreads subsequently rise, the investor’s existing contract becomes more valuable because new protection would now be more expensive.

The chart below represents a continuously updated rolling index that follows the current on-the-run CDX.NA.IG 5Y series.

When a new series is issued, the index rolls from the old series into the new one. CDX.NA.IG rolls typically occur in March and September, with the transition taking place gradually over several trading days.

Chart source:

https://markets.ft.com/data/indices/tearsheet/summary?s=UISYMI5S:RCT

Adapted From

John C. Hull, Options, Futures, and Other Derivatives, Chapter 24 — Credit Derivatives.