What are CDX and iTraxx credit indices, and how are they used for portfolio hedging and trading?
I'm studying credit derivatives for FRM Part II and keep encountering CDX and iTraxx indices. I understand they are baskets of CDS, but how are they constructed, how do you trade them, and what basis risk exists when using an index to hedge single-name exposure?
CDX (for North America) and iTraxx (for Europe and Asia) are standardized credit default swap indices. Each index references a basket of single-name CDS on investment-grade or high-yield corporate entities, providing liquid, tradeable exposure to broad credit risk.
Index Construction
The CDX IG (Investment Grade) index, for example, consists of 125 equally weighted North American investment-grade names. Key features:
- Roll dates: Every 6 months (March and September), a new series launches. Fallen angels (downgraded to HY) are removed and replaced.
- Fixed coupon: Each series has a fixed running spread (e.g., 100 bps). Trading occurs at a price that reflects the difference between the fixed coupon and the market spread.
- Standardized maturity: 5-year is most liquid, though 3-year, 7-year, and 10-year also trade.
Trading Mechanics
Suppose the CDX IG Series 42 has a fixed coupon of 100 bps and the current market spread is 65 bps. A protection buyer enters the index at a tighter spread than the fixed coupon, so they pay an upfront amount to the protection seller to compensate. The upfront payment approximates:
> Upfront ≈ (Fixed Coupon - Market Spread) x Duration x Notional
> Upfront ≈ (100 - 65) bps x 4.5 x $100M = $1.575M
After inception, the protection buyer pays 100 bps running.
Hedging with Indices: Ashford Capital Example
Ashford Capital holds $200M in single-name CDS protection sold on 15 investment-grade issuers. Rather than buying protection name-by-name, they buy CDX IG protection as a macro hedge.
The hedge works well for broad credit moves but introduces basis risk:
| Basis Risk Source | Description |
|---|---|
| Name mismatch | Ashford's 15 names may not perfectly overlap with the 125 CDX constituents |
| Idiosyncratic risk | A default in one of Ashford's names won't be offset proportionally by the index |
| Roll risk | When the index rolls to a new series, composition changes may alter the hedge |
| Curve risk | Single-name CDS may trade at different tenors than the 5-year index |
To quantify basis risk, Ashford computes the beta of their portfolio spread to the CDX spread. If the beta is 0.85, they need approximately $200M / 0.85 = $235M in CDX protection to hedge the systematic component, accepting that 15% of risk is idiosyncratic and unhedged.
FRM exam tip: Understand the difference between trading index CDS (standardized, liquid) and single-name CDS (customized, less liquid). Know how the upfront payment works with fixed coupons and that basis risk is the primary limitation of index hedging. Questions may ask you to calculate the required notional for an index hedge given a beta.
Check our FRM Part II materials for more credit derivatives content.
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