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The growth of the credit derviatives market has produced a liquid
market in credit default swaps across the credit curve, and this
liquidity has led many investors to access both the credit
derivative and cash bond markets to meet their investment
requirements.
This book investigates the close relationship between the synthetic
and cash markets in credit, which manifests itself in the credit
default swap basis. Choudhry covers the factors that drive the
basis, implications for market participants, the CDS index basis,
and trading the basis.
Credit market investors and traders as well as anyone with an
interest in the global debt markets will find this insightful and
rewarding.
THIS BOOK QUALIFIES FOR 7 PD CREDITS UNDER THE GUIDELINES OF THE
CFA INSTITUTE PROFESSIONAL DEVELOPMENT PROGRAM.
Good introduction, but only to the basisReviewed by David R. Harper, 2009-01-19
Please note "basis" in the title. It's a fine introduction to CDS
generally and a first pass at pricing (but nothing deep). But it is
undermined by the *unhelpful* way in which it uses Bloomberg
screens and spreadsheet screen shots (w/o actual spreadsheets). It
is short, here are my notes from the six chapters:
1. CDS Primer. He compares a bond (which compensates the investor
for credit, funding, interest rate and currency risk) to an asset
swap (compensation for credit and funding risk) to a CDS
(compensation for credit risk only). He helpfully shows how a CDS
transfers unfunded credit default risk.
2. Muddled introduction to swap rates which is decent but unduly
confusing becuase it lacks a good setup on swaps. The point is to
introduce the CDS basis which equals the difference between the CDS
spread (i.e., the premium paid by the protection buyer to the
protection seller) and the spread on the corresponding bond (Z
spread) or asset swap. In other words, in theory, we start with the
idea that the CDS basis should be zero because the premium received
on sold protection (CDS premium) on an underlying bond should equal
the credit spread on the same underlying bond, if we were to fund
the bond directly. The book is then largely about why this isn't
true, why the basis will vary from zero.
3. Factors behind the basis. I think this is helpful. The author
distinguishes fundamental factors from market factors. Both
contribute to the CDS basis. But their difference I think is
important. Fundamental factors can be designed into the contract;
i.e., in theory, the counterparties will demand compensation for
fundamental factors. For example, a CDS in unfunded, unlike a bond
which is funded. If an investor has high funding cost, he/she will
prefer the CDS and this drives down the basis. Another, more
topical fundamental factor is counterparty risk. The protection
buyer assumes counterparty risk (historically, margin collateral
only mitigates counterparty risk); this drives down the basis. I
would argue that consistent underpricing of true counterparty risk
(enabled by M2M and collateral netting practices) enabled the
unfunded CDS market to grow in the first place; if counterparty
risk were accurately priced (or posted collateral really covered
counterparty risk) in the first place, it's not clear the CDS
market would have had *half* its appeal.
Market factors include supply/demand, liquidity, and a few other
items which (IMO) can classify into supply/demand anyhow. The
reason it's helpful to grasp market factors is: typically our
pricing models cannot capture technical (market) factors. That's
why we don't expect pricing models to be accurate; due to techical
factors, we expect instruments to "trade rich" or "trade cheap"
relative to the price given by our models.
4. and 5. Illustrate the calculation of the *adjusted* CDS basis
which is the same CDS basis above (i.e., CDS basis - Z spread) but
the bond spread is adjusted/informed by the default information
contained in the CDS market quotes. Because the spreadsheet example
is clumsily displayed, it looks harder than it should.
6. Gives some trade applications, which are interesting. Negative
basis trades are simply: buy the bond and buy (CDS) protection on
the same bond, if the CDS spread is low. But the "advanced"
examples are difficult only because the book delegates explaining
terms likek DV01 to another book (?!).
The appendix gives an unwitting example of unnecessary
complication. Appendix III shows a spreadsheet to compute the
market-implied timing of default from CDS prices (i.e., using the
CDS to infer when the bond will default). No spreadsheet is
necessary and certainly no need to "goal seek". It is just a
breakeven analysis. It can be shown in a few sentences: 1.3 years =
$6 MM recovery / $4.6 MM annual premium.
Useful, but a bit disappointingReviewed by Nicolas Roth, 2008-07-09
I am usually a big fan of what Moorad Choudry writes, because of
his very accessible way of writing on bonds and structured finance
theory. But in this book, I had the feeling that the topic was not
covered as deeply as others topics he has written about.
1. This is not a book about CDS theory and pricing, so if you are
looking to get a grip on CDS, this book is not for you. However,
quite a number of pages are devoted on CDS, ASW, z-spreads. It is
interesting, but this is not the topic of the book and people
buying it are certainly all familiar with thoses concepts.
2. The part covering CDS basis is not really deep covered. Moorad
Choodry gives some explaination of the factors driving the basis
(which was what I was expecting in getting this book) but it could
have been done in an article rather than a book.
3. On how to trade the basis, the author gives some trades
examples, but he remains very high level on the rationale of the
trades and how to identify opportunities. It seems that there is a
missing part.
In conclusion, I would still recommend it because of it gives some
useful information on the CDS basis and its price is very
accessible. Overall, I continue to enjoy what Moorad Choodry
writes, but just a little disappointed on this one.
A great read for anyone interested in credit default swapsReviewed by Garrett A. Hartzog, 2008-01-22
In all honesty, I bought this book without fully realizing what I
was purchasing. I had intended to buy a very basic intro to credit
default swaps. With that being said, I'm glad I made the decision
to purchase the book. There was more than enough material covering
how a CDS works to get anyone familiar with finance up to
speed.
Once Choudhry gets into the basis itself, it's very easy to
understand and apply. I almost felt ready to go out and trade the
basis myself, but not working on a trade desk, that just wasn't an
option!
At the end of the day, one of the most valuable takeaways is that
you really have a much better understanding of the difference
between the cash and synthetic market. I've personally used what
I've learned in this book to help people make sense of what CDS and
asset-swap spreads mean.
This book could be boiled down to an article.Reviewed by J. Hull, 2007-03-27
The book is 195 pages total. The first 60 pages explain what CDS,
z-spread, and asset swap spread are. While this is useful
information, chances are, if you are buying a book about CDS basis,
you will already know this stuff. And if you dont, wikipedia or any
other online source can concisely explain it.
The last 50 pages includes definitions and appendicies. In between,
you get a lot of repetitive information. Every chapter starts out
with a 2-3 page summary of what you just read.
Chapter 3 is really the only useful part of the book - it outlines
the 10 or so factors that drive basis. I certainly learned a lot
here but it was in the course of 10 pages or so.
The final chapter talks about "trading the basis." I was
disappointed to read that they are simply telling you how to
execute the trade...ie, buy $10MM notional, sell X, hedge with
futures. It really doesnt help with idea generation which is what I
was hoping to see.
Very Useful For PractitionersReviewed by Jeff G., 2007-01-27
Choudhry lays out the relationship between cash and synthetic fixed
income instruments: 1) for cash bonds, the different ways to
measure the cash flows, swapping fixed to floating, using ASW, I
spread, Z spread, etc., and the pro's and con's of each
measurement. 2) For CDS, there is a brief primer on the CDS product
structure, and discussion of CDS pricing methodology (both
mathematically and in layman's terms). He then lays out techniques
for hedging and basis trading and presents examples. There is
discussion of market supply/demand influences.
The emphasis is hands-on usability for the practitioner. He
presents examples using the Bloomberg & some spreadsheets.
Although several approaches to CDS pricing theory are presented
(including some math that I'm not knowledgable enough to evaluate),
CDS theory is not explored or debated in great detail. This level
of theory is not the primary focus of the book. The book is NOT
targeted to heavy duty quants or theoreticians.
There are a couple areas where I would have appreciated a bit more
diligence. Choudhry himself points out one example where the values
in the printed Bloomberg screen differ slightly from the book's
text (couldn't they have updated one or the other before going to
print?). In another case, I was unsure about the consistency of
treatment in different parts of the book regarding one of the
spread measurements. In this case I will probably buy one of his
other books where the issue is examined in greater detail.
Overall, I found this book VERY useful and well worth reading.
