Nathan owns some intermediate-term bonds issued by ABC Company and has become concerned about the risk of a near-term default, although he is not very concerned about a default in the long term. ABC Company’s two-year duration CDS currently trades at 400 bps, and the five-year duration CDS is at 700 bps. Describe a potential curve trade that Nathan could use to hedge the default risk of ABC Company.
A) Nathan should position himself short in the short term CDS and short in the long term CDS.
B) Nathan should position himself short in the short term CDS and long in the long term CDS.
C) Nathan should position himself long in the short term CDS and short in the long term CDS.
Correct answer B. Explanation : The investor anticipates a flattening curve and can exploit this possibility by positioning himself short (buying protection) in the two year CDS while going long in the five-year CDS (selling protection).
The doubt is he is holding a bond for which he is concerned about short term default but not for long term. Means, he should long short term CDS and short long term CDS. In that sense, why not the correct answer C?
Nathan owns bond.
He is concenred short term yields will rise, CDS spread will increase, Price of CDS will fall
He wants to buy protection against this, which means going short the CDS instrument
Remember PRice CDS = (CDS Spread - CDS Coupon) x Duartion so in inversly related to yields
This costs him money he can offset this by selling protection longer term. Thinks long CDS will fall meaing price of CDS instrument will rise. So go Long CDS instrument.
This like (I know these are options and CDS is not) owning a share and been concerned about short term drop in price but bullish long term.
But short term put and write long term put.
The key here is Nathan’s concern about a near-term default but not a long-term one. In this case, to hedge against the risk, he wants to go short (buy protection) on the short-term CDS (two-year) while simultaneously going long (selling protection) on the long-term CDS (five-year).
When you’re trying to hedge against the risk of a default in a curve trade, what you’re really looking at is how credit spreads might move over different time periods. So let’s break down why answer (B) makes the most sense, and why (C) doesn’t cut it.
Curve trades are all about dealing with credit default swaps (CDS) that have different maturities. The goal? To cash in on expected changes in the yield curve. Now here’s why option (B) is your best bet:
Thinking the Yield Curve will Flatten:
In our case, Nathan is worried about a default happening soon, but isn’t so worried about the long run.
The structure of CDS spreads gives us a peek into what the market thinks the credit risk might be over different time frames.
So, if Nathan thinks the yield curve will flatten - meaning that the short-term CDS spreads will go up more than the long-term spreads - he’ll want to go short in the short term and long in the long term.
Playing the Short-Term and Long-Term CDS Game:
Nathan’s playing a smart game here. He’s shorting the two-year CDS (selling in the short term) and going long on the five-year CDS (buying in for the long run). He’s betting on what we call a ‘flattening of the yield curve’.
If there’s a default risk in the short term, his short position in the two-year CDS will have his back. On the flip side, his long position in the five-year CDS will cover him against any long-term default scares.
Now, let me break down this ‘flattening curve trade’ thing. When we say this, it means that the short-term CDS spreads will rise more than the long-term CDS spreads. Nathan’s hoping to cash in on the difference between short and long-term movements.
On the flip side, choice (C) is saying we should buy short-term CDS for protection. However, this doesn’t jive with our expectation of a flatter curve. The real winning move here is to sell the short-term CDS and buy the long-term CDS. That way, we can make the most of the predicted shifts in the spread.
So, when thinking about it in terms of a flattening curve trade, choice (B) is our better bet (sorry for a long essay)
I posted this question before I appeared Nov 2023 exam. I failed again for the second time, registered again for Nov 2024. Today I practiced the same question with Schweser, had the same doubt, came to this platform once again and here there is a notification about the reply to my question. What an irony!!!
Anyway, I found a short method to remember this concept, short/selling CDS means buying protection and long/buying CDS means selling protection. Nathan is concerned about short term default hence buy protection, that is short CDS and vice versa.