I have a basic question concerning contracts on Credit Derivative indexes:Assume I have sold protection on an (equity) tranche of some index, delta-hedging by buing protection on the index. Assume that for some reason the spread on the equity tranche narrows, while the spread on the whole index remains constant.What have I lost under this scenario? Isn't it that I still pay and receive spreads as at the beginning of my contract? In this case I even have won, as I still receive wider spreads compared to the market.Or is it that the spreads are adjusted (for my existing contracts, too)? In this case I could just sell both contracts, which would just leave me with a minor loss (the loss in the period where I didnt adjust my hedging strategy).Thanks for help.

You could say the same thing about bonds. Suppose I buy a corporate bond with a 5% yield, and short a 3% cash-flow-matched treasury bond. I receive 2% per year on the face amount, with zero net investment. If the spread on the corporate bond widens, I haven't lost any money, I still get my 2%. If I try to exit my position, however, I have to do it at a loss. If I keep my position, the market is telling me there is a greater probability of default loss.If you sell the equity tranche and buy delta hedged index protection, you're making a correlation assumption. If the equity tranche spread narrows relative to the index, the market is telling you correlations have gone up. You are no longer delta hedged. You will have mark to market losses as overall implied default probabilities go up and gains as they go down. If you exit your position, you will take a loss. If you hold on, you risk a large loss if several defaults occur, something the market told you was more likely than you suspected when you entered into the position.As a practical matter, the CDX Tranches are so complicated that the simple story above is misleading. But the general principle applies.