Need help in understanding CDS Application in LBO

CFA Level II Fixed Income
#1

Hi,

When a company X make an unsolicited bid at a premium to acquire all the tradable shares of Y through issue of debt…say 5 n 10-Senior unsecured bonds. How can one profit from a equity-versus credit trade involving X and Y.

  1. Short Y shares and short X 10 year CDS

  2. Long Y shares and short X 5 yr CDS

  3. Long X shares and Long X 5 year CDS

Is it not Long Y shares and Long X 5yr CDS?? The new debt will increase X’s credit spread as a result the CDS price must go up. However, the answer is option 2. How is this possible?

Thanks.

#2

The short position on the CDS is the protection buyer.

Straight from the text:

Because of these CDS characteristics, there is potential confusion regarding which party is long and which is short. Normally, we think of buyers as being long and sellers as being short, but in the CDS world, it is the opposite. Because the credit protection buyer promises to make a series of future payments, it is regarded as being short. This is consistent with the fact that in the financial world, “shorts” are said to benefit when things go badly. Credit quality is based on the underlying debt obligation, and when it improves, the credit protection seller benefits. When credit quality deteriorates, the credit protection buyer benefits. Hence, the CDS industry views the credit protection seller as the long and the buyer as the short. This point can lead to confusion because we effectively say the credit protection buyer is short and the credit protection seller is long.

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#3

Hi,

Thanks for the explanation. It was difficult for me to retain this through theory so, I took a different approach in retaining this concept permanently. I request you to validate my reasoning. It is as follows:

CDS price in currency per 100 par= 100-upfront premium

Upfront premium =(credit spread - coupon on CDS contract)*duration

So when credit quality of the underlying deteriorates, the credit spread will move up ---->upfront premium increases----> CDS price decreases.

So a short on CDS will benefit from decrease in CDS price. This means CDS short is the protection buyer…This is definitely lengthy but I can work it out from maths in case I forget it.

Thanks.