Credit Risk Exposure of a CDS Protection Seller
Summary
The document explains that a seller of credit default swap protection is short credit risk: the seller must pay when a credit event occurs and is exposed to losses as the reference entity’s credit deteriorates. It compares this position with holding a risky bond, which also loses value when credit spreads widen or default occurs. A protection buyer has the opposite directional exposure and generally benefits from spread widening or a credit event.
The discussion also distinguishes the positions’ carry. A protection seller receives the running spread, with any upfront payment depending on the market quote relative to that spread; a buyer pays the running spread and may pay or receive an upfront amount. CDS can provide a more direct way to express a credit view than a fixed-coupon bond, which also carries interest-rate exposure. The comparisons are conceptual and do not quantify spread sensitivity, recovery, or contract-specific settlement effects.
Key ideas
- A CDS protection seller is short credit risk because a credit event triggers a payment obligation.
- The seller’s exposure resembles holding a risky bond, including losses when credit spreads widen.
- A protection buyer has the opposite exposure and may gain when spreads widen or a credit event occurs.
- Running spreads and upfront payments affect carry for both sides of the contract.
- CDS generally has less interest-rate exposure than a fixed-coupon risky bond.
Tags
Full text
# default protection seller long or short credit risk? # default protection seller long or short credit risk? A default protection seller is long/short credit risk?my guess it is short the credit risk, anyone can help clarify? ## Answer by Vitomir (score 1) https://quant.stackexchange.com/a/46888 A default protection seller pays in case the credit event is triggered. Therefore, the risk he faces is the show up of the credit event. Therefore, he is short credit risk. ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/46893 It may help to consider the more familiar analogies with someone who is long a risky bond (or, in contrast, is short a risky bond, which can also be done as an alternative to buying CDS protection). Someone who is long a risky bond loses money if the bond defaults; and also loses money (unrealized loss) if the bond's credit spread widens. They make money (unrealized) if the bond's credit spread tightens. They earn the accrued coupons if there is no credit event, which is probably more than they pay for financing the bond, so the carry is positive. Conversely someone who is short a risky bond makes money if the bond defaults; and also makes money if the bond's credit spread widens. The view of someone selling CDS protection is similar to the view of someone long a bond, but the carry is somewhat different. After the upfront fee is paid, the protection seller is paid the running spread, and that's pretty much the entire (positive) carry. If the upfront fee is paid to the seller (i.e. market standard quote is wider than the running spread), then the seller also invests the upfront fee and earns some interest. If the market standard quote is tighter than the running spread, then the protection seller actually pays the upfront fee to the protection buyer. The view of someone buying CDS protection is likewise similar to the view of someone short a bond. After the upfront fee is paid, the protection buyer pays the running spread making their carry negative. If the CDS spread in the market widens, the buyer makes unrealized gain - they can unwind their CDS for more money. And if there is a credit event, then the buyer generally makes lots of money, and the seller generally loses a lot. (Further, a fixed-coupon bond has interest rates risk. Someone who does not want that (wants only to take a view on credit) would hedge the interest rates exposure. But a CDS has very little interest rates risk, and is more convenient for expressing view on credit risk alone.)
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.