FRM Part II · FRM Exam Part II · Credit Derivatives
A portfolio manager holds a USD 50 million long position in a corporate bond portfolio and wants to hedge broad investment-grade credit spread exposure quickly and cheaply, without selecting individual reference entities. Which instrument is most suitable?
Buying protection on a standardized CDS index such as CDX IG is best, because it gives liquid, low-cost hedging of broad investment-grade spread risk without choosing single names. Selling protection adds exposure, and basket or bespoke tranche products are narrower and less liquid.
- ABuying protection on a standardized CDS index such as CDX IGCorrect
- BSelling protection on a single-name CDS on one issuer
- CBuying a first-to-default basket on five issuers
- DSelling protection on an equity tranche of a bespoke CDO
Explanation
A standardized CDS index references a broad, liquid basket of investment-grade names, so buying protection offsets general spread widening at low cost. Selling protection would add credit exposure rather than hedge it. FTD baskets and bespoke equity tranches are narrow or illiquid and do not hedge broad exposure.
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