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Fancy Owning Protection For Free?

15 January 2015 by lberuti

Since oil began its free fall 6 months ago, investors started buying protection on names within the energy sector, driving their risk premia through the roof. Over the last 6 months, in the US, the average 5 year CDS of energy companies has widened by 175bps from 79bps to 254bps. RIG’s ( Transocean Ltd ) 5 year CDS has ballooned from 150bps to 853bps. To finance these CDS purchases, investors have sold credit indices, and in this instance CDX IG. These 2 contradicting forces (buyers of single name CDS and sellers of CDX IG) have been at work in the market since the launch of the series 23, and the quoted value of CDXIG23 has never traded above the theoretical value implied by its constituents. This chronically negative basis was worth -30cts at the close, but was down to -40cts during the session. At that point, buying protection on $125m index and selling 1m protection on all the constituents would have made you 500k$ (125m x 40cts). If you want to buy protection to December 2019 (the maturity of CDXIG23) on RIG and AVP ( Avon Products Inc ), which are the 2 widest names included in CDXIG23, you will have to pay 845bps and 690bps respectively, which over the course of life of these products (factoring in some default probability) will cost you roughly 300k$ and 260k$ to insure $1m of each. So why don’t you buy protection on $125m and sell protection on all the names in the index except RIG and AVP. That will (almost) not cost you a cent until December 2019 and you will effectively own $1m protection of each… That sounds better than buying single name CDS and selling index to get some carry back!