Trading Strategies in the Sovereign CDS Market

Abstract

The sovereign credit default swap (CDS) market has gained considerable importance since the start of the sovereign debt crisis. The authors examine typical trading strategies using sov CDS, including 1) hedging risk in the sovereign cash bond market, 2) earning carry by selling sov CDS protection, and 3) relative value trading around the CDS on a cash basis. Sov CDS are a good hedge against cash bonds of lower-rated countries, reducing portfolio volatility by an average of 40%, but they are not a good hedge for highly rated countries. When computing risk-adjusted carry in short sov CDS protection trades, default risk needs to explicitly be taken into account. The authors introduce a new metric, risk- and default-adjusted carry (RDAC) and find that 1) short-maturity sov CDS offers higher RDAC than long-maturity sov CDS, 2) higher-rated countries generally offer higher RDAC than lower-rated ones, and 3) Finland and the Netherlands offer the highest RDAC. They build an efficient frontier of sov CDS trades and conclude that investors can significantly increase RDAC via portfolio diversification by selling front-end protection across several countries in optimized proportions. CDS–cash basis trades have been profitable, on average, when initiated using simple trading rules, and they have yielded an average information ratio of 2.2 since the beginning of the crisis.

TOPICS: CLOs, CDOs, and other structured credit, credit default swaps