CFA CFA Level 2 CDS understanding

CDS understanding

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    • SbS
      Participant
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      Long CDS position expects the bond(reference obligation) price to go up due to improvement in credit quality.(credit spread decrease).

      So a Long CDS position means CDS (credit protection) seller. Can unwind position by buying CDS at lower price or may hold on to position earning premiums till expiration.

      And a Short CDS position means CDS buyer.

      Is above understanding correct?

    • Sophie Macon
      Keymaster
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      Yes this is right. I nearly got confused myself!

      Can be confusing but in the CDS world, as the concept of long/short seems “inverted”.

      Let me explain my line of thought to remember:

      It may sound confusing because we think Buy Protection = Long, Sell Protection = Short.

      In finance, going long means we benefit when “something” improves and going short when something deteriorates. In CDS world this is the same concept, and this “something” is credit quality.

      So, when we buy (sell) protection we actually hope that the credit quality will go down (up), so we can benefit from the trade. That means when buying protection we hope credit quality will deteriorate, and selling protection – credit quality will improve.

      To conclude:

      Buy Protection => Credit Quality to deteriorate = Short Position Sell Protection => Credit Quality to improve = Long Position

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