Single-Name, Index, and Basket Swaps

Introduction

If you’ve taken a peek at modern credit markets, you’ve probably noticed that credit derivatives play a huge role in how investors manage and trade credit risk. Credit Default Swaps (CDS) are at the heart of this market. They enable you to hedge or speculate on the creditworthiness of an entity—be it a single company, a group of companies, or even an entire index of issuers. In this article, we’ll look at three critical variations in the world of CDS: Single-Name CDS, Index CDS, and Basket CDS. I remember the first time I encountered a Basket CDS in a live trading scenario—it felt pretty complicated, with the possibility of first-to-default or second-to-default triggers. But once you break it down step by step, it’s not that terrifying.

We’ll explore each product, how it’s used, and why correlations between the entities in the CDS matter so much. We’ll also consider some best practices and potential pitfalls from a risk management perspective. Let’s jump right in.

Single-Name CDS

A Single-Name Credit Default Swap (SN-CDS) is, as the name suggests, a contract in which two parties exchange credit risk on one specific reference entity—often a corporate or sovereign issuer. Think of it like an insurance policy on a single bond issuer:

• The buyer of protection pays a periodic premium (the CDS spread) to the seller.
• If the reference entity defaults, the seller compensates the buyer (usually the notional minus the recovery value).

It’s that straightforward, at least in concept. But as you can guess, the details can get a bit more involved when you consider legal definitions of default, settlement mechanics, and the interplay with broader markets.

Mechanics in a Nutshell

Here’s a simple illustration of how a Single-Name CDS works:

    graph LR
	A["Protection Buyer"] -- "Periodic Premium <br/> (CDS Spread)" --> B["Protection Seller"]
	B["Protection Seller"] -- "Contingent Payment <br/> (if Default)" --> A["Protection Buyer"]
	C["Reference Entity"] -- "Credit Risk Observed" --> B["Protection Seller"]

• Protection Buyer: Pays a premium (in basis points per year on the notional).
• Protection Seller: Receives premium, but bears the risk of making a default payment.
• Reference Entity: The underlying issuer on which credit risk is transferred.

Why Use Single-Name CDS?

1. Hedging: If an investor holds a bond issued by XYZ Corp, they might purchase a CDS on XYZ to hedge the default risk of that bond.
2. Speculation: If you believe XYZ Corp’s credit quality will deteriorate (i.e., spreads will widen), you might buy protection. If spreads do widen, the market value of your CDS can go up, allowing you to close the position at a profit.
3. Relative Value: Investors look for mispricings between a company’s bond yield and its CDS spread, creating arbitrage or spread-trading opportunities (see Chapter 7 on Arbitrage, Replication, and Cost of Carry).

Simplified Valuation Formula

In a plain-vanilla Single-Name CDS, the annualized spread S is often approximated by:

Where:
• \( p \) = Probability of default over the contract’s life.
• \( R \) = Recovery rate (fraction of par expected to be recovered if default occurs).
• Discount Factor captures time value of money.

This formula is just a simplified snapshot. Actual pricing models get more sophisticated with hazard rates, survival probabilities, and calibration to market data.

Index CDS

Now, what if you want to hedge or gain exposure to a broad swath of companies rather than just one issuer? That’s where Index CDS come into play.

An Index CDS references a standardized basket of corporate or sovereign issuers. For instance, the iTraxx indices in Europe or the CDX indices in North America each represent a list of issuers. By trading the index, you get (or hedge) exposure to the average credit risk of that entire basket.

Composition and Rebalancing

Indices like iTraxx and CDX are rebalanced periodically—often every six months. Entities that have defaulted are removed, new ones might be added based on market capitalization, rating, or other criteria, and the index composition is kept fairly up-to-date. This periodic reset is helpful for maintaining a representative sample of the broader credit market. It’s also an important detail for pricing, because the index’s level and composition will shift over time.

Why Use an Index CDS?

• Quick Exposure: Let’s say you have a broad-based bearish view on the consumer goods sector in North America. You can short the relevant CDX index to reflect that view in a single trade, rather than shorting the CDS of each corporation individually.
• Hedge a Portfolio: If your fund is long a portfolio of corporate bonds, you might buy protection via an index to hedge systematic credit risk.
• Liquidity: Index CDS tend to be more liquid than many single-name CDS contracts, especially those on smaller issuers. That means tighter bid–ask spreads and deeper markets.

Basket CDS

Basket CDS take a middle-ground approach between Single-Name and Index CDS. They reference multiple entities—but not necessarily the broad, standardized set you’d find in an index. Rather, you might have a custom selection of, say, five or ten issuers.

First-to-Default vs. n-th-to-Default

Basket CDS can further specify how losses are triggered:

• First-to-Default Swap: The contract triggers a payout when the first entity in the basket defaults. After that, the contract typically ends (though variations exist). Premium payments stop once the first default occurs.
• n-th-to-Default Swap: Payout occurs only if the n-th default in the basket happens. For instance, in a second-to-default basket swap, no payout occurs if only one name defaults—that’s not enough. The second name to default triggers the protection payment.

The choice between first-to-default, second-to-default, or higher is not just for fun; it radically changes the risk profile. A first-to-default basket swap is typically more expensive for the protection buyer because the chance of at least one entity defaulting is obviously higher than waiting for the second or third.

Why Use Basket CDS?

• Targeted Multi-Name Exposure: Suppose you want to hedge or speculate on a handful of auto manufacturers rather than a broad index. You can create a custom basket of just those issuers.
• Fine-Tuned Cash Flows: The structure of n-th-to-default can let you precisely tailor how and when you receive payout.

The Role of Correlation

Correlation among reference entities has a major role in pricing Multi-Name CDS—whether an index or a basket. If individual reference entities are highly correlated, the probability that multiple issuers default around the same time changes, influencing how quickly (or eventually) a multi-default event might occur in an n-th-to-default swap.

High correlation typically increases the likelihood that multiple defaults will cluster. This probability affects:
• The spread you pay or receive for basket CDS.
• The implied correlation priced into index tranches if you break the index into layered “slices” of risk.

When correlation is low, defaults tend to happen more independently. This can actually increase the cost of protection for first-to-default instruments if you suspect one of the names might default but can boost the cost of higher-order default swaps if many defaults are unlikely to cluster.

Practical Examples and Case Studies

Single-Name CDS Example

Let’s say you own $10 million of Company A’s 5-year bonds. You’re worried about Company A’s deteriorating financials. The current market quotes a 200-basis-point CDS spread (2% per year). If you buy protection on $10 million notional:

• You pay 2% of $10 million = $200,000 per year, often in quarterly installments.
• If Company A defaults, you get (Notional - Recovery) from the protection seller. Assuming a 40% recovery, the payment would be $6 million if the notional was $10 million.

Index CDS Example

Imagine you hold a broader portfolio with 50 different corporate credits, many of which are in the CDX High Yield index. If you sense the high-yield market might face a systemic sell-off, you can buy index CDS protection on CDX High Yield. This approach gives you:

1. Systemic Hedge: Offsets your broad exposure in one fell swoop.
2. Liquidity: Typically strong liquidity in main indices.
3. Simplicity: A single trade for broad coverage.

Basket CDS Example

You’re concerned about, say, the top five cyclical companies in your industrial holdings. They each have some correlation because they move with broader economic cycles, but not perfectly. You create a first-to-default basket swap referencing these five names:

• If any one of these five defaults, your protection triggers.
• You pay a spread that reflects the possibility that at least one will default and how correlated they are.
• If correlation is high, your basket might be considered riskier in a multi-default sense, affecting the premium.

Best Practices and Pitfalls

• Thorough Documentation: A single name might seem straightforward, but remember that credit event definitions, restructuring clauses, and settlement mechanics can vary.
• Correlation Risk: With baskets or indices, correlation is sometimes overlooked. If correlation studies are incomplete, you might misprice the risk.
• Monitoring Credit Events: Index and basket CDS will remove or replace defaults over time, so keep up with rebalancing.
• Liquidity Risk: Single-name CDS on smaller issuers or specialized basket structures may not be as liquid as the main index, so factor in potential wide bid–ask spreads.
• Counterparty Risk: Don’t forget that you are exposed to your CDS counterparty. If the seller of protection can’t pay, your hedge or speculative position might blow up (see Chapter 6.4, “Counterparty Risk in OTC Markets”).

Exam Relevance and Final Tips

Given the significance of credit derivatives in risk management and speculation, expect to see scenarios on the CFA exam (especially at more advanced levels) that test your understanding of Single-Name, Index, and Basket CDS. They might give you: • A portfolio containing a variety of corporate bonds.
• A broad macro environment hinting at rising credit spreads.
• The choice of how best to hedge credit risk or speculate on defaults.

Be prepared to:
• Calculate or compare hypothetical CDS spreads.
• Analyze the impact of correlation in a basket.
• Determine how an index hedge might offset risk in broader portfolios.

Time management is key—practice reading vignette details carefully: • Identify the underlying reference entity or entities.
• Parse out the type of payout (first-to-default vs. nth-to-default).
• Understand the notional amounts and premium calculations.

Take time to review how to compute implied spreads or at least reason about relative value. The exam may not require deep stochastic models, but it might test your conceptual understanding of how correlation or shifting credit conditions affect spreads.

Further Reading

• Gregory, J. (2012). Counterparty Credit Risk and Credit Value Adjustment. Wiley.
• MarketAxess on Indices:
(https://www.marketaxess.com/)
• O’Kane, D. (2018). Modelling Single-Name and Multi-Name Credit Derivatives. Risk Books.
• For deeper insights into baskets and tranches: Chapter 5.8 Correlation and Risk in Credit Portfolios.
• Also see Chapter 7 for broader arbitrage and replication strategies.

Test Your Knowledge: Single-Name, Index, and Basket Swaps Quiz