How to hedge Total return swap using CDS

[MongKoo]

Dear all,

How to hedge Total return swap using CDS?

 

[David Harper CFA FRM]

Hi MongKoo,

According to the FRM methodology, a CDS hedges credit default and (if market to market) credit deterioration risk; i.e., credit risk. But a CDS does not (cannot) hedge market risk itself, and therefore a CDS cannot hedge total return (total return is a function of exposure to credit and market risk).

Rather it is the total rate of return swap (TRS or TROR) instrument which hedges against total return.

This means that, although a "naked" CDS (ie., long or short a CDS only) does NOT hedge total return, the CDS plus a long/short position in the underlying does hedge total return. That is:

• If underlying exposure is long (owning) the asset, then a total return hedge is given by:
• Long a M2M CDS (i.e., hedging credit risk) on the underlying plus short a risk-free asset (i.e., hedging market risk). If interest rates increase, the drop in value of underlying is hedged by increase in value of short position in the risk-free asset.

Equivalently:

• protection buyer in TRS/TROR (aka, payer) can hedge with:
• Short CDS + long RF asset
  i.e., TRS payer is short credit risk & market risk, which is hedged by short CDS (long credit) and long RF asset

Or:

• protection seller in TRS/TROR (aka, receiver) can hedge with:
• Long CDS + short RF asset
  i.e., TRS receiver is long credit risk: if reference defaults, long CDS hedges the loss.
  Also, TRS receiver is long market risk: if rates increase, the TRS receiver's loss on the value decline is hedged by the short position in RF asset.

I hope that helps, thanks!

 

[MongKoo]

 

[MongKoo]

Hi MongKoo,

According to the FRM methodology, a CDS hedges credit default and (if market to market) credit deterioration risk; i.e., credit risk. But a CDS does not (cannot) hedge market risk itself, and therefore a CDS cannot hedge total return (total return is a function of exposure to credit and market risk).

Rather it is the total rate of return swap (TRS or TROR) instrument which hedges against total return.

This means that, although a "naked" CDS (ie., long or short a CDS only) does NOT hedge total return, the CDS plus a long/short position in the underlying does hedge total return. That is:

• If underlying exposure is long (owning) the asset, then a total return hedge is given by:
• Long a M2M CDS (i.e., hedging credit risk) on the underlying plus short a risk-free asset (i.e., hedging market risk). If interest rates increase, the drop in value of underlying is hedged by increase in value of short position in the risk-free asset.

Equivalently:

• protection buyer in TRS/TROR (aka, payer) can hedge with:
• Short CDS + long RF asset
  i.e., TRS payer is short credit risk & market risk, which is hedged by short CDS (long credit) and long RF asset

Or:

• protection seller in TRS/TROR (aka, receiver) can hedge with:
• Long CDS + short RF asset
  i.e., TRS receiver is long credit risk: if reference defaults, long CDS hedges the loss.
  Also, TRS receiver is long market risk: if rates increase, the TRS receiver's loss on the value decline is hedged by the short position in RF asset.

I hope that helps, thanks!

Thanks for your reply. It really helped a lot.

 

[andred0250_]

Hi MongKoo,

According to the FRM methodology, a CDS hedges credit default and (if market to market) credit deterioration risk; i.e., credit risk. But a CDS does not (cannot) hedge market risk itself, and therefore a CDS cannot hedge total return (total return is a function of exposure to credit and market risk).

Rather it is the total rate of return swap (TRS or TROR) instrument which hedges against total return.

This means that, although a "naked" CDS (ie., long or short a CDS only) does NOT hedge total return, the CDS plus a long/short position in the underlying does hedge total return. That is:

• If underlying exposure is long (owning) the asset, then a total return hedge is given by:
• Long a M2M CDS (i.e., hedging credit risk) on the underlying plus short a risk-free asset (i.e., hedging market risk). If interest rates increase, the drop in value of underlying is hedged by increase in value of short position in the risk-free asset.

Equivalently:

• protection buyer in TRS/TROR (aka, payer) can hedge with:
• Short CDS + long RF asset
  i.e., TRS payer is short credit risk & market risk, which is hedged by short CDS (long credit) and long RF asset

Or:

• protection seller in TRS/TROR (aka, receiver) can hedge with:
• Long CDS + short RF asset
  i.e., TRS receiver is long credit risk: if reference defaults, long CDS hedges the loss.
  Also, TRS receiver is long market risk: if rates increase, the TRS receiver's loss on the value decline is hedged by the short position in RF asset.

I hope that helps, thanks!

Referring to 209.2C, the TRS payer position is economically most similar to C. Short a credit risk free asset plus long a CDS (based on the solutions); the solutions go on to say "long CDS hedges credit risk and short risk free rate hedges market (interest rate) risk." Unless I am misunderstanding something, this contradicts the above. If I understand correctly to hedge against the credit risk of TRS (i.e. hedge the potential failure of the protection seller to make interest payments) you long a CDS; assuming the underlying pays a fixed rate of interest, your only other exposure is market risk associated with an increase in value of the reference asset which you would hedge by a call option. Can you please clarify?

 

[David Harper CFA FRM]

Hi @andred0250_ I'm not following you, sorry, and I don't see the discrepancy between my comment above and question 209.2; the source to this question 209.2 is located here at https://forum.bionicturtle.com/thre...ivatives-total-return-swaps-topic-review.6217 and includes my subsequent clarifying comment:

"Hi james 2 I think I agree with the first part of your sentence ("are you shoring credit risk-free asset to correlate the view that decrease in market value" but long the CDS is to correlate with default (credit quality) of the underlying. The total return swap payer (seeking protection) is short the credit quality and market price of the underlying. The long CDS correlates the the short credit quality. But if we just stop with the long CDS, we have not "synthesized" the TRS because, for example, an increase in interest rates (i.e., market risk) will impact the TRS but will not impact the CDS, so the short position in the credit-risk-free asset is added to "correlate" with the decrease in market value that would attach to the TRS.

Another way to look at this is algebraically per the a full decomposition of the M2m CDS , which is:

• Long CDS (buy default protection)= short risky bond + long cash (i.e., deposit funds into default-free asset) + fixed-rate receiver IRS (i.e., neutralize bond's market risk); and
• Short CDS (sell default protection)= long risky bond + short cash (i.e., borrow to fund bond purchase) + fixed-rate payer IRS

Then we can look at the TRS in terms of two synthetic equivalents, albeit these are the funded-equivalent bets (TRS are unfunded)

• Long CDS (buy default protection) + short cash (borrow) = short risky bond + fixed-rate receiver IRS; i.e., synthetically equivalent to a funded TRS payer (protection buyer)
• Short CDS (sell default protection) + long cash (i.e., deposit into default-free asset) = long risky bond + fixed-rate payer IRS; i.e., synthetically equivalent to funded TRS receiver (protection seller)."

... my comment above is a full decomposition, but as far as I can tell, 209.c and this thread are consistently asserting:

• TSR Payer (aka, protection buyer) = long CDS + short risk-free asset (209.2); which is the same as above:
• "then a total return hedge is given by: Long a M2M CDS (i.e., hedging credit risk) on the underlying plus short a risk-free asset (i.e., hedging market risk)" and please note the following is hedge: "protection seller in TRS/TROR (aka, receiver) can hedge with: Long CDS + short RF asset"

In neither case, is the CDS or TSR counterparty risk hedged, as this concerns replication of the TSR (and I don't see why the call option needs to enter, sorry). I hope that's helpful,