Can someone please explain to me how buying a CDX and then taking a short CDS position generates alpha? I am so confused.
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$\begingroup$ I voted to close this because it's unclear what you're asking. A long index/short CDS position will generate profits if the index (CDX) goes up by more than the CDS. It will generate losses if the index goes up by less than the CDS, like any other long/short position. Traders look at the "skew" (the difference between the index spread and the theoretical spread derived from the constituents) to get an idea of whether the index is under- or over-priced, e.g. see ihsmarkit.com/research-analysis/Remember-the-Skew.html $\endgroup$– Chris TaylorCommented Aug 20, 2019 at 9:55
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One can argue that the theoretical fair value (intrinsic value) of a credit index is just the sum of values of its component CDSs on the same names and with the same terms and conditions (maturity, running spread, etc) as the index. Sometimes the index is being quoted in the market far enough from the fair value (this difference is called the "skew") that one can arbitrage, e.g. buy CDS protection in the form of the index and at the same time sell the same CDS protection in the form of many single-name CDSs on small notionals, referencing index components, make some PL at inception (despite bid-offer spread and other transaction costs), and then can be considered risk-free (all the cash flows offset each other) until all the trades mature.
This is similar to how some arbitrage desks look for opportunities to trade simultaneously an equity index, and a replictating portfoloio of its component equities.
Many practical obstacles make a credit trade more difficult. For example, CDS on many components can be extremely illiquid with a very wide bid-offer spread. Also you're not completely risk-free - if you have dozens of OTC swaps with different counterparties, then someone needs to think about your CVA.
answered Aug 20, 2019 at 10:05
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1$\begingroup$ If I may add, looking at dispersion trading can be beneficial, in a fashion of implied vs realized correlations $\endgroup$– VitomirCommented Aug 20, 2019 at 11:50
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1$\begingroup$ Thank you! That cleared up a lot of confusion I had $\endgroup$ Commented Aug 21, 2019 at 11:10
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$\begingroup$ I don't think the dispersion of the index (or any correlation of index components) affects a vanilla index trade, only more complicated products like tranche of an index or option on an index, or oth to default, etc. $\endgroup$ Commented Sep 7, 2019 at 17:12