Discussion in 'P2.T6. Credit Risk (25%)' started by MongKoo, Jun 24, 2012.
How to hedge Total return swap using CDS?
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!
Thanks for your reply. It really helped a lot.
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