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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory
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To: Ramsey Su who wrote (71348)10/7/2006 5:52:10 PM
From: YanivBA  Read Replies (3) of 110194
 
As far as I understand the ABX is a credit default swap index for mortgage backed bonds. It covers only defaults. When you sell a credit default swap you do not have to commit capital and therefore you do not earn interest on your capital. You only receive a premium for your obligation to cover defaults.

Technically a CDS has nothing to do with the market interest rate (on government bonds). Its price is theoretically related to the spread between the underplaying bond and a similar maturity safe bond but in reality the price is simply determined by supply and demand for the CDS.

The price of a CDS contract is associated with estimated risk. If estimated risk is high the spread will widen and CDS protection would rise in value. If estimated risk is low the spread would tighten and CDS protection would be sold for less.

The DJ CDX index is built to simply reflect this price movement. Higher risk equals higher CDX and lower risk equals lower CDX. You can think of the DJ CDX index somewhat like you think on the VIX. It is actually quite like a VIX for corporate bonds.

The ABX index was set up in reverse. Higher risk equals wider spreads equals lower ABX. Lower risk equals tighter spreads equals higher ABX. Why they did it this way is anybody's guess. My guess is that it's more like a stock or a bond that way and therefore it is easier to market. It really makes no practical difference.

YanivBA.
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