How to hedge Total return swap using CDS

Discussion in 'P2.T6. Credit Risk (25%)' started by MongKoo, Jun 24, 2012.

  1. MongKoo

    MongKoo New Member

    Dear all,

    How to hedge Total return swap using CDS?
  2. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    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.
    • 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
    • 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!
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  3. MongKoo

    MongKoo New Member

  4. MongKoo

    MongKoo New Member

    Thanks for your reply. It really helped a lot.
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