cdx spread description

CREDIT DEFAULT SWAP SPREAD

APPLICABLE TIME FRAME(S):

INTERMEDIATE

UPDATE SCHEDULE:

Each weekday night by 7:00 PM EST

EXPLANATION:

Over the past few years, one of the fastest-growing derivatives markets is that for credit default swaps (CDS). A CDS allows the various parties to swap the exposure of default of the underlying credit (i.e. bond).

For example, the investor of a relatively risky bond might be uncomfortable that the issuer of the bond could default on their payments. To hedge that risk, the investor buys a CDS.

When they buy the CDS, the investor pays another trader (the seller) a periodic payment. That other trader then takes on the risk that the issuer of the bond will default. If that happens, then the seller is responsible for paying the bond investor an agreed-upon amount.

This allows the original investors to offset some of their risk, it allows the seller to generate a stable flow of income, and it allows the bond market to enjoy more liquidity. Of course, just like selling options, the seller of a CDS takes on possibly large risks, and a major system-wide event could trigger a massive wave of trouble since this market has become so huge.

The indicator as posted to the site tracks an index created by Dow Jones which monitors the spread between credit default swaps on high-yield (i.e. junk) bonds and Treasury securities. The higher the index, the wider the spread...this means that credit investors are more and more worried about defaults and are willing to pay higher prices for default protection.

GUIDELINES:

This is a relatively new indicator, and it will take some time to sort out just how it behaves in times of crisis.

We expect it to track volatility measurements like the VIX quite closely as times of fear should see this index spike higher and times of complacency should see it become very subdued. In that sense, it is a contrary indicator.

On the chart, we have inverted the scale of the indicator so that overbought readings are more easily compared to equity market highs and vice-versa. We have also included a stochastic indicator which compares current readings in the indicator to those in the recent past.

What we want to look for are times of extreme in the indicator. When the stochastic is very low (which, because of the inverted scale, will be high readings on the chart - above the red dotted line), we can conclude that investors are quite comfortable and that may mean trouble for the market as a whole.

On the other hand, when the stochastic falls below its green dotted line, then there is a fair amount of fear in the market and we will want to generally look for rising equity prices going forward.

ADDITIONAL RESOURCES:

Markit (www.markit.com)

Wikipedia entry for Credit Default Swap (http://en.wikipedia.org/wiki/Credit_default_swap)