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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?

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Why would you not just offset the position as you would with futures contracts before committing to receiving physicals or having to deliver? Hardly any credit desk ever trades/makes markets to truly insure a credit portfolio. –  Matt Wolf Mar 12 '13 at 8:18
    
With a position in the underlying bond you mean? –  Benjamin Kjellson Mar 12 '13 at 8:21
    
No, you buy the CDS you sell it, you sell the contract, you buy it back. By the way, I am strongly assuming you are with an entity that can trade OTC fixed income derivatives, correct? –  Matt Wolf Mar 12 '13 at 8:23
    
Ok: having bought the CDS, I sell it before having to make the next quarterly payment, and vice versa, having sold the CDS, I'd sell it before—when? Default? (might be hard). I guess as a seller I would like to receive the quarterly payment. –  Benjamin Kjellson Mar 12 '13 at 8:32
    
The quarterly fixed coupons that the protection buyer pays are priced into the contracts. When you "terminate" the contract/position all that is done is that the protection buyer sells the protection, accrued interest up to the termination date is settled, and the difference in spreads is settled as well. And please note you do not necessarily need to offset the position prior to each quarterly settlement dates, you could in 2 opposing contract positions simply weight the notional so that the same amounts are paid and received. –  Matt Wolf Mar 12 '13 at 8:35
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up vote 3 down vote accepted

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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