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A CDS Index Tranche is a credit derivative used to take a position on a basket of credit reference securities. Unlike a credit default swap index, the seller of credit protection does not necessarily lose money as soon as any loss occurs within the reference index. Instead the seller only pays losses once they reach a set amount (the "attachment point") and ceases to be liable for further losses once they exceed an upper limit (the "detachment point").

In principle an index tranche is merely any CDS on a credit index that has an attachment point and detachment point. In practice, traders almost always use tranches with standardized attachment and detachment points and other terms. Index tranches may therefore be more liquid than similar CDOs on bespoke portfolios.

These tranches are carved out of the standardized CDS indices and have traded since late 2003. The most liquid standardized tranches are based on the following three underlying portfolios: • CDX IG (125-name, investment grade) • iTraxx Europe (125-name, investment grade) • CDX HY (100-name, high yield)

The standardized tranche market initially grew out of dealers’ need to hedge out exposure to bespoke single-tranche synthetic CDOs which provided investors who sold these tranches with enhanced yield. The development of the standardized tranche market also led to correlation price discovery and an observable market view of correlation for a particular portfolio. Besides enabling better pricing of bespoke tranches, it also helped dealers release correlation reserves. Standardized tranche trading which was primarily a dealer activity has attracted more of the other investors including hedge funds, banks, insurance companies and private clients.

Investment Grade Standardized Tranches The most liquid single-tranches are those carved out of the two main investment grade indices: (a) CDX IG index in North America and (b) iTraxx Europe index in Europe. Each of these indices has five liquid tranches as shown in Table 6. Each tranche is defined by its (a) attachment point which defines the level of subordination of a tranche, and (b) detachment (or exhaustion) point which defines the maximum loss of the underlying portfolio that would result in a full loss of tranche notional. For example, the 3-7% tranche implies a 3% attachment point and a 7% detachment point. In our discussion of these tranches, we generally refer to the on=the-run tranches that are derived from the on-the-run indices

The 2003 ISDA Credit Derivatives Definitions govern all tranche contracts. In North America, the underlying CDX IG portfolio has two credit events: Bankruptcy and Failure to Pay. iTraxx Europe, however, has three credit events: Bankruptcy, Failure to Pay and Modified-Modified-Restructuring (mod-mod-R). Tranches of both indices are typically cash settled. Following the Delphi (DPH) default in 2005, CDX IG tranches were cash settled in an orderly manner. The market uses standard confirmations to trade tranches. This lowers basis risk as an investor with a tranche exposure to one dealer can offset it via a trade with another dealer.