Application of Credit Derivatives in Portfolio Management

Abstract

The use of credit derivatives has grown considerably over the past decade, with participation from a diverse set of institutional investors. Specifically, investors increasingly are using credit default swaps (CDS), credit default swap indices (CDX), and options on CDX to manage their portfolios. In this article, the authors demonstrate how investors apply credit derivatives in the context of portfolio management. The authors show how CDS can be used to create synthetic corporate bonds and how investors structure basis trading opportunities by taking advantage of mispricing between CDS and corporate bonds. Further, the authors illustrate how investors apply options on CDX for the purpose of hedging the tail risks of a fixed income portfolio, and they include a discussion on various methods to reduce the cost of such tail-risk-hedging strategies.