Deconstructing CDX & iTraxx: Understanding the Index Construction and Roll

The Architecture of Credit Default Swap Indices: CDX and iTraxx

Credit Default Swap (CDS) indices are standardized, tradable instruments that represent a basket of single-name CDS contracts. The two most prominent families of CDS indices are the Markit CDX indices, which cover North American and Emerging Market corporate entities, and the Markit iTraxx indices, which cover European and Asian entities. These indices provide an efficient way for investors to gain or hedge exposure to broad segments of the credit market.

Index Construction: A Rules-Based Approach

The construction of the CDX and iTraxx indices is a rules-based process designed to ensure transparency and representativeness. The indices are reconstituted on a semi-annual basis, in March and September, in a process known as the "roll."

• Liquidity is Key: The primary criterion for inclusion in the indices is liquidity. The most actively traded single-name CDS contracts are selected to be part of the index. This ensures that the index is a reliable reflection of the most liquid part of the credit market and that the index itself is tradable.
• Sector Representation: The indices are also designed to be representative of the broader credit market in terms of sector diversification. The number of entities from each sector is determined by the overall composition of the credit market.
• Fixed Number of Constituents: Each index series has a fixed number of constituents. For example, the CDX North America Investment Grade (CDX.NA.IG) index has 125 constituents, while the iTraxx Europe Main index has 125 constituents.

The Biannual Roll: Maintaining Relevance

The semi-annual roll is a important process for maintaining the relevance and tradability of the CDS indices. As the credit quality of individual companies changes and new entities become more prominent in the market, the composition of the indices needs to be updated.

• On-the-Run vs. Off-the-Run: The most recently issued index series is known as the "on-the-run" series. Previous series are referred to as "off-the-run." Liquidity is concentrated in the on-the-run series, and most market participants roll their positions into the new series at each roll date.
• The Roll Process: The roll process involves determining the new constituents of the index, setting the new fixed coupon, and establishing the new on-the-run series. This process is managed by IHS Markit, the administrator of the CDX and iTraxx indices, in consultation with a consortium of dealer banks.
• Maintaining Duration: The fixed tenor of the CDS indices (typically 5 years) means that investors can maintain a consistent duration in their credit exposure by rolling their positions into the new series at each roll date.

Trading and Settlement

CDS indices are traded over-the-counter (OTC) but are highly standardized and are typically cleared through a central counterparty (CCP). This reduces counterparty risk and increases market transparency.

• Fixed Coupons and Upfront Payments: Like single-name CDS, the indices trade with a fixed coupon. The difference between the fixed coupon and the market-implied spread is settled through an upfront payment at the inception of the trade.
• Credit Events: If a constituent of the index experiences a credit event, a new version of the index is created that excludes the defaulted entity. The notional amount of the index is reduced, and a new version of the index begins trading. The settlement of the defaulted portion of the index is handled through the standard credit event auction process.

Conclusion

The CDX and iTraxx indices have become the cornerstone of the credit derivatives market. Their standardized construction, transparent roll process, and high liquidity make them indispensable tools for a wide range of market participants, from hedge funds and asset managers to banks and insurance companies. A thorough understanding of the index construction and roll process is essential for anyone looking to trade or invest in the credit markets.