CDS Index

A CDS index bundles credit default swaps on a whole roster of borrowers — 125 investment-grade companies in the flagship CDX.IG (North America) and iTraxx Europe indices, 100 in the high-yield versions — into a single contract.

One trade buys or sells default protection on the entire list at once. The index spread is the market's temperature reading for credit conditions overall: tight and calm at 50bp, feverish at 150bp, crisis at 800 (high yield in 2008 fashion).

Because it's vastly cheaper and faster than trading 125 individual names, the index is where credit views get expressed first — the hedge of choice when a portfolio manager smells recession, and the punt of choice when they don't.

How the machinery runs

• The roll: every March and September a new "series" starts with an updated constituent list (fallen angels out, new names in). Liquidity concentrates in the on-the-run series.
• Fixed coupons: 100bp (IG) / 500bp (HY) running, difference settled upfront — same convention as single names.
• Defaults: when a constituent has a credit event, its slice pays out via auction and drops from the index; the contract continues on the survivors with reduced notional.
• Versions: HY trades on price (like a bond), IG on spread — a market-convention quirk.

The ecosystem on top

• Index options ("swaptions on credit"): payers/receivers on the index — the liquid market for credit volatility and crash hedges.
• Tranches: the index sliced into loss layers (0–3%, 3–7%, …) — standardised synthetic CDOs that trade correlation.
• The skew: index spread vs. the average of its constituents' single-name spreads; arbitrageurs trade the difference.

Pricing and the intrinsic skew

The index's fair value is the duration-weighted aggregate of constituent hazard curves; deviations define the skew:

Persistent skew reflects macro-flow demand for the index vs. idiosyncratic pricing of names, plus transaction-cost bounds on the arbitrage (trading 125 names). Skew trades package the index against a replicating single-name portfolio.

Index options

Quoted on forward spread/price with Black-style models; the subtlety is front-end protection — the option must account for defaults between trade and expiry (the "no-knockout" feature), handled via the FEP adjustment. The credit vol surface's skew prices systemic gap risk, and its steepness is a monitored stress indicator.

Tranche correlation

Tranches on the index reprice the loss distribution's shape: equity tranches long idiosyncratic risk/short correlation, seniors the reverse. The market quotes base correlations per detachment; their movement decomposes market moves into "average spread" vs. "systemic-ness". The 2005 correlation unwind and 2012's "London Whale" (massive IG9 tranche positions) are the market's cautionary tales.

Risk usage

Index CS01 hedges portfolio beta cheaply, but leaves single-name basis and curve residuals — quantified via regression hedge ratios (empirical beta of portfolio spread to index spread, typically > 1 in selloffs).