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!
