How is the CDX credit index constructed, and how do investors use it for hedging and speculation?

The CDX (Credit Default Swap Index) is the most widely traded credit derivative index in North America and a key Level II topic.

What CDX Is:

A CDX index is a standardized portfolio of single-name CDS contracts, equally weighted, referencing a specific set of corporate entities. It allows investors to gain or hedge broad credit exposure with a single trade.

CDX Families:

Construction Process:

1. Selection — A dealer consortium (IHS Markit/S&P) selects the reference entities based on CDS liquidity
2. Equal weighting — Each name carries 1/125th (or 1/100th) of the notional
3. Semi-annual roll — New series launched every 6 months (March and September). Composition is refreshed — defaults are removed, replacements added
4. Standardized terms — Fixed coupon (typically 100 bps for IG, 500 bps for HY), 5-year maturity, quarterly payments

How Trading Works:

CDX trades like a CDS but on the entire portfolio:

• Buy protection (go short credit): Pay the fixed coupon, receive payout if any index constituent defaults
• Sell protection (go long credit): Receive the fixed coupon, pay out on defaults

If the CDX.NA.IG spread widens from 65 bps to 90 bps, protection buyers profit (credit deteriorated) and protection sellers lose.

Upfront Payment Convention:

Because CDX has a fixed coupon (e.g., 100 bps for IG), the market spread determines an upfront payment:

• If market spread > fixed coupon: Protection buyer receives upfront payment
• If market spread < fixed coupon: Protection buyer pays upfront

Use Cases:

1. Macro hedging — A corporate bond portfolio manager buys CDX protection to hedge systematic credit risk
2. Basis trading — Exploit the difference between CDX spreads and the average single-name CDS spreads (the 'index basis')
3. Relative value — Trade CDX.IG vs. CDX.HY to express views on credit quality rotation
4. Curve trades — Buy protection on 5-year CDX, sell on 3-year CDX to trade the credit spread term structure

Example: Cypress Capital holds $500M in investment-grade corporate bonds and is concerned about a credit market selloff. Instead of selling individual bonds (costly and slow), they buy $500M notional of CDX.NA.IG protection. If spreads widen 50 bps, the CDX position gains approximately $500M x 50 bps x 4.5 (duration) = $11.25M, offsetting the portfolio losses.

Exam Tip: Know the basic construction (125 names for IG, equally weighted, semi-annual roll), understand buying vs. selling protection, and be able to explain how CDX is used for hedging and speculation.

Learn more about credit derivatives in our CFA Level II course.