Do CDS Indices Measure the Credit Risk of the Whole CDS Market?
An empirical study on CDS indices' ability to track systematic credit risks of the market
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CDS indices are widely accepted as market indicators for systematic credit risks and tools for credit risk correlation trading. This paper examines the major North America and European CDS Indices on their abilities to capture the systematic risk of the overall CDS market. Through designing and constructing two synthetic CDS indices that represent the North America and European CDS markets respectively, we compare the current CDS indices and the synthetic indices from the perspective of index methodology, rating and sector composition, spread levels and movements as well as return movements. R...
CDS indices are widely accepted as market indicators for systematic credit risks and tools for credit risk correlation trading. This paper examines the major North America and European CDS Indices on their abilities to capture the systematic risk of the overall CDS market. Through designing and constructing two synthetic CDS indices that represent the North America and European CDS markets respectively, we compare the current CDS indices and the synthetic indices from the perspective of index methodology, rating and sector composition, spread levels and movements as well as return movements. Results show that iTraxx has strong trackability of the overall CDS market regarding all tested factors. Although the trackability of CDX is satisfactory, there is room for improvements on the sector composition and its explanatory power on market CDS spread returns. The paper finds that both indices reveal certain weaknesses in capturing markets tail risks and that their liquidity-oriented index methodology can lead to biased reflection of the overall CDS spread level when the market is in stress. In addition, the constituent pool of both indices should be expanded so as to well diversify idiosyncratic risks.
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