Why Cointegrated CDS Pairs Carry Credit and Tail Risks
Summary
The document considers whether cointegration between sovereign credit default swap spreads can guide a pairs trade, and how to interpret hedge weights derived from spread levels versus log spreads. Its main response warns that CDS positions do not behave like cash equity positions: buying protection resembles owning an option, with premium payments and a bounded direct loss, while selling protection earns premium in return for potentially large credit-event liability.
The answer argues that a paired CDS position may retain substantial exposure to volatility, correlation, and issuer-specific credit events even when spreads move together historically. Cointegration therefore does not establish that the trade is hedged or safe, and the relationship may break down. The response recommends examining each leg's risk independently, including for index CDS. It offers a qualitative risk argument rather than a sizing procedure, test results, or a worked example, and it particularly emphasizes single-name CDS exposure.
Key ideas
- Protection buyers pay premiums and face a different payoff profile from cash-equity longs.
- Protection sellers receive premiums but can owe large amounts after a credit event.
- Cointegration between CDS spreads does not ensure that a paired position hedges disaster risk.
- A CDS pair can retain volatility, correlation, and issuer-specific risks.
- Analyze each CDS leg independently before relying on a spread relationship.
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Full text
# Pairs trade CDS contracts using cointegration # Pairs trade CDS contracts using cointegration Recently I have looked at some sovereign CDS spreads (of the Nordic countries to be precise) and have tested for cointegration in the levels (i.e. untransformed) and logs of the spreads. Tests indicate that a cointegrating relationship exists between certain pairs. My questions are: how would one go about setting up a pairs trade (if that is the proper word here) using the cointegrating vector from either the CDS spreads or the log CDS spreads? What would be the difference between logs and levels? As I understand it, when using e.g. stock prices, if using the stock prices as they are, the cointegrating vector would tell you how many of each stock to buy (when it is time to buy), and using logs, the cointegrating vector will tell you the relative weights in dollars to place in each stock. However, when using CDS contracts, e.g. as the buyer, we commit to making quarterly payments based on the spread, to receive protection (a payout) in case of a credit event. How would this translate into a pairs trading strategy? ## Answer by Matt Wolf (score 3, accepted) https://quant.stackexchange.com/a/7504 I urge you to not compare CDS contracts and pairs with cash equity pair trades. The profiles are entirely different. CDS pairs are much more similar to being long and short an options contract. As protection buyer you are essentially long an option, you pay an "insurance premium" and that is what you are standing to lose at maximum. However, as protection seller you are paid premium for a potentially large liability in the case an "event is triggered". Trading CDS contracts as pairs and believing you can in any way hedge away disaster is asking to load the cart with toxic waste, so to speak. I already am very critical about anyone claiming they have a "perfect" equity pairs trading strategy. Unsystematic risks are ensuring time and again that the most co integrated pairs are ripped apart as if there is no tomorrow. As mentioned above, your CDS pairs are a lot more complex in terms of risk exposure. You are basically short volatility and correlation and I am not sure that is ever a prudent long-term strategy (unless you are a market maker and have accepted for yourself and are fine with the fact that most market makers selling volatility and selling correlation are going bust on a very frequent and stable cycle). All of the above obviously applies more to single name CDS rather than CDS indexes. I would strongly urge you to take the trade apart and trade each leg on its own, even when trading CDS indexes.
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