I apologize in advance for the rather esoteric subject here, but I have in the past done some work with our CDS index trading desk. The roll dates for the US indexes are once again approaching. Immediately after the roll date we trade both the old index, the new index, and the roll between them. The terminology, and what we are buying and selling, confuses us poor developers no end. It is immensely confusing because of the price/spread conventions.
At the last roll I wrote some notes on this, which I’m publishing here to help anyone else struggling with the market.
This article focuses on the US CDS index trading market, and uses the Markit CDX indexes as examples. This isn’t a general introduction to those markets, rather it’s a discussion of the mechanics of the market and what the bid/offer spreads actually mean.
I have written a general introduction to the credit default swap market. Markit themselves have guides to the index markets (see the Primers section).
CDS Index Pricing
Some indexes trade on spread (e.g. CDX IG), some on price (e.g. CDX HY). The series of articles on credit default swaps include a description of what these terms mean.
Indexes That Trade On Spread
In many ways spread is easier to think about. In March 2012 some real prices quoted by a dealer were 90.0/90.5 for the CDX NA IG 18 index, 84.25/85.0 for the CDX NA IG 17, and 5.50/5.69 for roll. I explain what these numbers actually mean below.
The Index Bid/Offer When Trading on Spread
The 18 price of 90.0/90.5 means that as a customer we pay the equivalent of a running premium of 90.5 to buy protection against defaults in the index, we receive 90.0 to sell protection. Of course we don’t actually pay that premium, we pay a fixed premium of 100 and an upfront fee that adjusts for the difference to the quoted spread of 90.5.
Note we pay more (90.5) to buy protection than we receive (90.0) to sell protection as a customer (obviously, the dealer makes their spread). We are buying protection at the offer (90.5). So to ‘buy’ here means to buy protection.
The Roll When Trading On Spread
A roll trade is designed to swap a position in the old index into a position in the new index. So you will sell protection in the old index and buy it in the new index, or vice versa.
The roll was trading at 5.50/5.69. When you ‘buy the roll’ (at 5.69) you are buying protection on the 18, selling it on the 17. I’m swapping a ‘long’ (bought protection) position in the 17 for a long position in the 18.
However, for reasons we shall see later it’s easier to think about bid and offer here. If I buy the roll I’m trading at the offer price (5.69): I’m lifting the offer. When I do that I’m also trading at the offer price for the 18, but trading at the bid price (hitting the bid) for the 17.
To calculate what trades you enter into at what prices if you trade the roll, you start with the 18 and work out the 17 from the roll spread. You subtract the roll spread from the 18 price. Note that this applies to indexes that trade on spread only: see below.
In this case if I buy the roll, I’m buying the 18 at the 18 offer (90.5) and calculate the 17 bid as 90.5-5.69 = 84.81. Note that this is a better price for me than the actual outright 17 bid (84.25): I effectively receive premium at 84.81 instead of 84.25.
Note also that I haven’t crossed the spread on the 17: I’m trading at an implied 17 bid of 84.81 but this is still less than the offer of 85.00. For obvious reasons this is an important check for a trader.
If I sell the roll at 5.50, I’m selling the 18 (at 90.0) and the implied 17 offer is 90.0-5.5 = 84.5, again a better price to me than the outright price of 85.0.
Indexes That Trade On Price
The CDX HY index trades on price. In March 2012 some real prices quoted by a dealer were 97.56/97.75 for the CDX NA HY 18 index, 98.75/98.94 for the CDX NA HY 17 index and 1.19/1.31 for the roll.
The Index Bid/Offer When Trading On Price
Here buy protection/sell protection is reversed from above because of the way the index is quoted. The 18 price of 97.56/97.75 means that as a customer I still ‘buy’ at the offer (97.75). However, now this number is used to calculate my upfront fee directly, rather than referring to a notional spread over the life of the trade. As discussed in my earlier article, the calculation is 100-price = points, and points is the percentage we apply to the notional to calculate the fee.
As discussed earlier, for the dealer to make money the customer has to pay more to buy protection than they would receive to sell protection. Here if I ‘buy’ at 97.75 the associated fee is 2.25% of the notional, if I ‘sell’ at 97.56 the associated fee is 2.44% of notional.
What this means is that for the dealer to make money I’m actually buying protection at the bid (97.56) and selling protection at the offer (97.75), which is the reverse of trading on spread.
It’s no wonder us poor developers get confused by this.
So for the HY index we are quoting ‘like a bond’. If I buy the 18s at the offer (97.75) this is like entering a long bond position (buying a bond), going short protection.
To recap, the percentage fee I actually pay is 100 minus the quoted spread, so for the 18s this is 2.44/2.25. So I receive 2.25 if I sell protection, pay 2.44 if I buy protection (percent of the notional).
The Roll When Trading On Price
The roll was trading at 1.19/1.31.
If I lift the offer on the roll (1.31) then I’m lifting the offer on the 17 and hitting the bid on the 18 (97.56). Note that’s the reverse of what I did above for the IG. This is just the convention: I explain why it’s the convention below.
However this is the SAME trade as lifting the offer on the roll for the IG in terms of buying/selling protection: I’ve sold protection on the 17, bought protection on the 18.
As for the IG we derive the 17 price for the roll from the 18 price and the roll spread. Here we add. Again I explain why this is the convention below.
So if I lift the offer on the roll I’ll calculate the implied 17 offer price by adding the roll offer price to the 18 bid price.
That is, the implied 17 = 97.56 + 1.31 = 98.87. So we’ve sold protection on the 17 at 98.87, which means we receive more upfront fee than if we’d just lifted the offer on the outright 17 (98.94): remember we actually receive 100 minus the value here. So the customer again gets a better deal by trading the roll than by trading the two outrights.
Note also we haven’t crossed the spread for the 17 (98.75 < 98.87 < 98.94).
Summary of Calculations When You Trade a Roll
Trading on Spread
New index 90.0/90.5
Buy roll (lift offer), old index bid price = 90.5-5.69 = 84.81 (old bid = new offer – roll offer)
Sell roll (hit bid), old index offer price = 90.0-5.50 = 84.5 (old offer = new bid – roll bid)
Trading on Price
New index 97.56/97.75
Buy roll (lift offer), old index bid price = 97.75+1.19 = 98.95 (old bid = new offer + roll bid)
Sell roll (hit bid), old index offer price = 97.56+1.31 = 98.87 (old offer = new bid + roll offer)
Explanations for the Roll Conventions
The first thing to note is that in general it costs more to buy protection and you receive more if you sell protection in the newer index. This is because the protection is for six months longer. You may also have already had defaults in the old index so fewer names are being covered. However, the index constituents are revised to include more liquid and better-quality credits and this can offset this effect to some extent.
Roll Spread Convention
This means that if you are trading on spread (new index spread- old index spread) is positive, because the new spread is larger, regardless of buy protection/sell protection. We want to quote a positive spread, so we make that the calculation for our roll spread.
If you are trading on price then things are reversed: (old index price – new index price) will be positive, so we make that our roll spread. This is because the upfront fee is larger for the new index (it costs more to buy protection), so the actual price we quote is smaller for the new.
Hence the difference in the roll calculations: if trading on spread to get the old index spread we subtract the roll spread from the new index spread, if trading on price to get the old index price we add the roll spread to the new index price.
The bid/offer conventions now follow from the above. For both price conventions we will always have one trade at the bid and one at the offer in a roll. We are always buying one index and selling the other. There are alternative ways of quoting to those described above. However, if we quote with the conventions described above we always have offer greater than bid, and are always buying protection on the newer index if we buy the roll, so it makes sense to do it this way.
I warned you it was confusing: hopefully this article at least gives some idea of what’s going on.