Credit derivative indices are used for a wide range of purposes, including varients of all the strategies discussed under ‘single name trading strategies’ (see page 23). One of the most common applications is to provide a macro hedge. Buying protection on the credit derivative index allows users to hedge themselves against a general downturn in the credit market. Sometimes, they express a positive view on a particular credit, sector or tranche, but buy protection on the index as an overall hedge.
Another important use for the index is for asset managers and CDO managers that need to put allocated funds to work quickly, before they have had a chance to select or find specific assets which they believe will outperform the market.
Because of their low execution costs, credit indices are also the product of choice for hedge funds, which often want to place short term bets on the direction of the market. As a result, indices are often used in momentum trades, where traders believe they can ride the general direction of the market for a short period.
Hedge funds and other relative value traders also use index swaps in curve steepening and curve flattening trades. Some hedge funds and proprietary trading desks also trade the index versus all its component single name credit default swaps to arbitrage the basis to theoretical.