Trading Credit Index Skew Against Its Single-Name CDS Components

Summary

A credit index can be compared with a portfolio of single-name credit default swaps that references the same constituents on matching terms. If the index and the component portfolio diverge sufficiently in value, the difference, called skew here, may create a relative-value opportunity. The described position buys protection through the index and sells equivalent protection across its component CDS contracts, seeking an upfront gain while offsetting later credit cash flows.

The replication logic resembles trading an equity index against its constituent shares. The explanation is conceptual and does not provide market data or a worked valuation, so it does not show how to identify or size an actual trade. Practical frictions can overwhelm the apparent mispricing: constituent CDS may be illiquid and costly to trade, and using many over-the-counter counterparties introduces counterparty exposure and credit valuation adjustment concerns. The position is therefore not necessarily risk-free even when its intended cash flows offset.

Key ideas

• The theoretical value of a credit index can be compared with the value of matching CDS contracts on its constituents.
• A sufficiently large index-to-components pricing gap may support a relative-value trade.
• Buying index protection and selling component protection aims to offset credit cash flows while capturing the initial difference.
• Illiquidity, bid-ask costs, and counterparty exposure can erode the apparent arbitrage.

Tags

# How does buying a CDX and then taking a short CDS position generates alpha?


# How does buying a CDX and then taking a short CDS position generates alpha?












Can someone please explain to me how buying a CDX and then taking a short CDS position generates alpha? I am so confused.

## Answer by Dimitri Vulis (score 3)

https://quant.stackexchange.com/a/47208

One can argue that the theoretical fair value (intrinsic value) of a credit index is just the sum of values of its component CDSs on the same names and with the same terms and conditions (maturity, running spread, etc) as the index. Sometimes the index is being quoted in the market far enough from the fair value (this difference is called the "skew") that one can arbitrage, e.g. buy CDS protection in the form of the index and at the same time sell the same CDS protection in the form of many single-name CDSs on small notionals, referencing index components, make some PL at inception (despite bid-offer spread and other transaction costs), and then can be considered risk-free (all the cash flows offset each other) until all the trades mature.

This is similar to how some arbitrage desks look for opportunities to trade simultaneously an equity index, and a replictating portfoloio of its component equities.

Many practical obstacles make a credit trade more difficult. For example, CDS on many components can be extremely illiquid with a very wide bid-offer spread. Also you're not completely risk-free - if you have dozens of OTC swaps with different counterparties, then someone needs to think about your CVA.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.