Basis Trades with CDS

CFA Level II
#1

Could someone confirm if I understand this correctly. The premium paid on a CDS should be the same as the compensation for credit risk on a bond (i.e. if we want to transfer credit risk to another party, we would have to give them the portion of the yield that reflects credit risk). If there is no arbitrage opportunity, then the CDS Premium minus the asset swap spread should equal the compensation for credit risk - this is the cash default basis (page 361).

If the cash default basis and cds premium are not equal, then we can earn an arbitrage profit without taking on any credit risk. If there is a positive basis then the cds premium is 70bp and compensation on bond is 60bp we can sell the cds (long credit risk) and sell the bond (short credit risk) and net 10bp for free. If the premium were less - then we do the opposite trades.

What I dont get is the example at the end of the paragraph - they say to go long on the bond and then short the CDS. Selling CDS and buying a bond doesn’t net the credit risk, so how is this an arbitrage? Shouldn’t it be that we buy the CDS?

We pay 46 bp to transfer risk yet receive 60 bp to assume risk on the bond, so we can net 14bp.

Please help. Thanks.

#2

Pretty much correct.

CDS terminology is different – going long means selling CDS. going short means buying CDS.

Not sure your first paragraph is right, asset swap spread also includes compensation for credit risk. my understanding is that the asset swap spread on a 5-yr bond should be (close to) the same as the five year CDS premium. if not, there is a basis arbitrage opportunity like you explained.

Also this normally only works when the basis is negative (CDS premium lower than asset swap spread, therefore you buy the bond and buy the CDS) because in many markets it is tough/impossible to short actual bonds.

Cheers!

#3

Yes you’re right. Got confused by the diagrams.

Asset Swap spread is the spread over the reference rate used in a swap contract with the bond (such as LIBOR).

It should reflect the credit risk of the bond therefore Asset Swap Spread should = CDS Premium. If not, an arbitrage is possible using the bond and CDS.