-1
$\begingroup$

A default protection seller is long/short credit risk?my guess it is short the credit risk, anyone can help clarify?

$\endgroup$
1
$\begingroup$

A default protection seller pays in case the credit event is triggered. Therefore, the risk he faces is the show up of the credit event. Therefore, he is short credit risk.

$\endgroup$
  • 3
    $\begingroup$ This is not correct. Selling protection is the same as being long credit, as it is the same direction as owning a bond from the issuer outright given you are betting the company will not default. $\endgroup$ – Bond wiz Aug 1 at 1:26
1
$\begingroup$

It may help to consider the more familiar analogies with someone who is long a risky bond (or, in contrast, is short a risky bond, which can also be done as an alternative to buying CDS protection).

Someone who is long a risky bond loses money if the bond defaults; and also loses money (unrealized loss) if the bond's credit spread widens. They make money (unrealized) if the bond's credit spread tightens. They earn the accrued coupons if there is no credit event, which is probably more than they pay for financing the bond, so the carry is positive.

Conversely someone who is short a risky bond makes money if the bond defaults; and also makes money if the bond's credit spread widens.

The view of someone selling CDS protection is similar to the view of someone long a bond, but the carry is somewhat different. After the upfront fee is paid, the protection seller is paid the running spread, and that's pretty much the entire (positive) carry. If the upfront fee is paid to the seller (i.e. market standard quote is wider than the running spread), then the seller also invests the upfront fee and earns some interest. If the market standard quote is tighter than the running spread, then the protection seller actually pays the upfront fee to the protection buyer.

The view of someone buying CDS protection is likewise similar to the view of someone short a bond. After the upfront fee is paid, the protection buyer pays the running spread making their carry negative. If the CDS spread in the market widens, the buyer makes unrealized gain - they can unwind their CDS for more money. And if there is a credit event, then the buyer generally makes lots of money, and the seller generally loses a lot.

(Further, a fixed-coupon bond has interest rates risk. Someone who does not want that (wants only to take a view on credit) would hedge the interest rates exposure. But a CDS has very little interest rates risk, and is more convenient for expressing view on credit risk alone.)

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.