I think I understand what is going on here… The CDS premium is the amount you must pay for credit protection (short credit risk). In this case we are compaing the premium to the asset swap spread (bond’s yield above a benchmark swap rate), which should in theory reflect only credit risk. So if the CDS premium is lower than the premium on the asset swap then you have to pay less for credit risk than the market is pricing currently. If I go long the bond I am taking on both interest rate risk and credit risk. Of which the credit risk portion is a higher spread than what my CDS says I have to pay. Said another way, I am getting paid more for credit risk than I have to pay to insure against it. So I am long credit risk by buying the bond and short credit risk by buying the CDS. My arbitrage comes from the negative basis difference between the two. Sound right?
you wrote: “So I am long credit risk by buying the bond…” This is true but by buying the bond you are also long interest rate risk as well. Isolate the credit risk by shorting the Asset Swap instead of buying the bond. Now hedge (i.e. protect) this credit risk by buying protection via paying the CDS spread. The difference between the ASW and the CDS spread is the arbitrage profit. You seem to understand this in the begining of your post. ================= In reality though there will be acceptable (i.e. no arbitrage) differences between the ASW and CDS spreads. This is due to the fact that the CDS risk is based on a bond at ***par***. This is what a protection seller must pay (minus post credit event bond price) in the event of default. The ASW spread reflects that the risk in the event of a credit event starts from the ***market price*** of the underlying bond. In other words the ASW level has to be adjusted before comparison for the extent that the market price is away from par. Thankfully this is out of scope.
jackoliver Wrote: ------------------------------------------------------- > you wrote: > > “So I am long credit risk by buying the bond…” > This is true but by buying the bond you are also > long interest rate risk as well. > Isolate the credit risk by shorting the Asset Swap > instead of buying the bond. > Now hedge (i.e. protect) this credit risk by > buying protection via paying the CDS spread. True…understand that. > > The difference between the ASW and the CDS spread > is the arbitrage profit. > > You seem to understand this in the begining of > your post. > > ================= > In reality though there will be acceptable (i.e. > no arbitrage) differences between the ASW and CDS > spreads. This is due to the fact that the CDS risk > is based on a bond at ***par***. This is what a > protection seller must pay (minus post credit > event bond price) in the event of default. The > ASW spread reflects that the risk in the event of > a credit event starts from the ***market price*** > of the underlying bond. > Great. This makes sense. > In other words the ASW level has to be adjusted > before comparison for the extent that the market > price is away from par. > Won’t worry about this as I am living in the CFAI theoretical world right now. > Thankfully this is out of scope. Appreciate the response.