Portfolio Management Pathway · Fixed-Income Active Management: Credit Strategies

Credit Default Swap Use in Portfolio Management

Updated 8 October 2026 · Fact-checked

A credit default swap (CDS) transfers credit risk. The protection buyer pays a fixed spread and is compensated if a credit event occurs. Managers sell protection to add credit exposure, buy protection to hedge, and use CDS indexes for broad moves. To solve questions, identify the view, pick the position, then size it.

Understand Credit Derivatives and Structured Credit in Portfolios

A credit default swap is a contract on credit risk. The protection buyer pays a periodic premium, the CDS spread. The protection seller pays if a credit event occurs, such as bankruptcy or failure to pay. The seller's position behaves like owning a bond: it gains when spreads tighten and loses when they widen. The buyer's position behaves like shorting the credit.

This gives a manager a cheap, fast way to change credit exposure without trading bonds. To add exposure, sell protection. To reduce or hedge it, buy protection. A manager can also hold a government bond and sell protection to create a synthetic credit position. This is useful when the cash bond is scarce, illiquid or costly to trade.

A single-name CDS covers one issuer. A CDS index covers a basket of issuers, so it expresses a view on a whole market or sector and diversifies idiosyncratic risk. Indexes are usually more liquid than single names and cheaper to trade. Buying protection on an index is a quick way to cut market-wide credit risk. Selling protection adds it.

The CDS-bond basis is the CDS spread minus the bond's credit spread. A negative basis means the CDS spread is below the bond spread. A manager can buy the bond and buy protection, locking in the extra spread if the bond and CDS reference the same issuer and the terms match. A positive basis favours selling the bond and selling protection. The trade carries risks: mismatched maturities, cheapest-to-deliver and funding differences, and counterparty risk.

Structured credit such as CDOs and other tranched products repackages credit risk into tranches. Senior tranches are protected by subordination and carry lower spread. Equity and junior tranches absorb first losses, carry higher spread and are highly sensitive to correlation and defaults. Managers use them to target a specific risk-return slice. They also bring complexity, model risk and liquidity risk. Always tie any use to the mandate, risk budget and constraints.

Key rules to remember

Approximate CDS price change: ΔCDS value ≈ −(Δ spread) × EffSpreadDur × notional; Sign is for the protection seller: if spreads widen, the seller loses and the buyer gains. Effective spread duration of the CDS is similar to that of a bond of the same maturity.
CDS-bond basis: Basis = CDS spread − bond credit spread; Negative basis: buy bond and buy protection. Positive basis: sell bond (or avoid) and sell protection. Requires matched issuer and maturity.
Hedge notional for credit exposure: Hedge notional = Position value × (Bond spread duration ÷ CDS spread duration); Matches spread sensitivity so the hedge offsets spread moves. It does not remove default-timing or basis risk.
Synthetic credit position: Government bond + sold CDS protection ≈ corporate bond; Approximate. Differences come from basis, counterparty risk and funding.

How to solve Credit Derivatives and Structured Credit in Portfolios questions

Use this order for any CDS or structured credit question. It keeps your answer tied to the client's mandate.

1Read the objective and constraints: return target, risk budget, liquidity needs, derivative limits and benchmark.
2State the credit view: spreads widening or tightening, market-wide or issuer-specific.
3Choose the instrument: single-name CDS for an issuer view, CDS index for broad or sector view, bond or structured tranche when the mandate needs funded exposure.
4Choose the direction: sell protection to add exposure, buy protection to reduce or hedge.
5Size it: match spread duration or DV01 where the hedge or exposure target is numeric. Show the working.
6Check the basis and any matched terms: issuer, maturity, currency, seniority.
7Name the main risks: counterparty, basis, liquidity, correlation and model risk for tranches.
8Give the recommendation in one clear sentence with the reason.

Quickest way: Direction and sizing in four checks

When to use it: Use when the item set asks which position to take or how large a hedge should be, and time is short.

Ask: do I want more or less credit risk? More means sell protection. Less means buy protection.
Ask: broad or single issuer? Broad means index. One issuer means single-name.
Size by spread duration ratio: notional = exposure × bond duration ÷ CDS duration.
Eliminate options that ignore basis risk, counterparty risk or the stated constraint.

Common mistakes in Credit Derivatives and Structured Credit in Portfolios

Mixing up who pays and who is exposed.
Protection buyer sounds like the one taking the risk.
Fix: Protection seller is long credit risk, like a bond holder. Buyer is short credit, like a short bond position.
Calling a hedge with an index perfect for a single bond portfolio.
Index and holdings seem similar in sector or rating.
Fix: State that an index hedge leaves idiosyncratic and basis risk. Single-name CDS hedges closer to the exposure.
Using the wrong sign for basis.
Basis defined in either direction in different sources.
Fix: Use CDS spread minus bond spread, as defined here. Negative means CDS is cheap relative to the bond.
Ignoring counterparty risk and liquidity.
Focus on the calculation only.
Fix: Add at least one risk and a mitigation, such as central clearing or collateral.
Treating senior and equity tranches as having similar sensitivity.
Both are parts of the same pool.
Fix: Junior tranches take losses first and carry more risk and spread. Senior tranches are protected by subordination.

Worked examples

Example 1

A manager holds ₹50,00,00,000 of corporate bonds with spread duration 4.5. She wants to hedge spread risk using a CDS with spread duration 5.0. What notional of protection should she buy, and what happens if spreads widen by 20 bps?

Show the solution

Hedge notional = 50,00,00,000 × (4.5 ÷ 5.0) = 50,00,00,000 × 0.9 = ₹45,00,00,000.
Bond loss from 20 bps widening ≈ 4.5 × 0.0020 × 50,00,00,000 = ₹45,00,000.
CDS gain ≈ 5.0 × 0.0020 × 45,00,00,000 = ₹45,00,000.
The gain offsets the loss, ignoring basis and counterparty risk.

Answer: Buy protection with a notional of ₹45,00,00,000. The bond loss of about ₹45,00,000 is offset by an equal CDS gain.

Example 2

A fund manager expects investment-grade spreads to tighten broadly. The mandate allows derivatives, and the manager wants to raise credit exposure quickly with low trading cost. Which trade fits, and what risk should be noted?

Show the solution

The view is broad spread tightening, so a market-wide instrument fits.
Adding exposure means taking a long credit position, so sell protection.
An investment-grade CDS index is liquid and cheap to trade.
Main risks: spreads could widen instead, causing losses; counterparty risk if uncleared; mismatch with the fund's own holdings (basis risk).

Answer: Sell protection on an investment-grade CDS index. It raises credit exposure quickly and cheaply. Note the loss if spreads widen, and counterparty and basis risk.

Exam tips

Match the command word: if asked to justify, give the view, the position and one reason. Do not write an essay.
Always state direction in words: sell protection to add risk, buy protection to hedge.
Show the duration ratio in your calculation. A correct number alone earns credit, but working protects you if the setup is wrong.
Tie the choice to a constraint such as liquidity, derivative limits or benchmark tracking.
For tranche questions, rank risk by seniority and mention correlation and model risk.

Credit Derivatives and Structured Credit in Portfolios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Credit Derivatives and Structured Credit in Portfolios: frequently asked questions

How does a manager hedge credit risk with CDS?

Buy protection on the issuer or an index that matches the holdings. Size the notional by spread duration so spread moves offset. Some basis, counterparty and default-timing risk remains.

What is the difference between a CDS index and a cash bond position?

A CDS index is an unfunded, liquid, diversified exposure to a basket of issuers. A cash bond position is funded and issuer-specific, and may be harder to trade. The two can trade at different spreads, which is the basis.

What does a negative CDS-bond basis mean?

The CDS spread is lower than the bond's credit spread. A manager can buy the bond and buy protection to capture the difference. This works only if terms match and the risks are acceptable.

Why use structured credit in a portfolio?

Tranches let a manager choose a specific slice of credit risk and return. Senior tranches suit lower risk, and junior tranches suit higher risk. They add complexity, liquidity and model risk.