In basis trading, they say that the yield on the bond could be decomposed into 1. funding spread and 2. credit spread.
How come the funding spread would be different than the credit spread? You would expect that they would be the same, given that an investor would only lend to a borrow at a cost that covers the borrows credit risk.
Take a look at pp. 277, 278 in the curriculum:
- The funding spread is LIBOR − risk-free rate
- The credit spread is is yield − LIBOR
There’s no reason for them to be the same, or even remotely close to each other.
My question is more along the lines of the intuition of why this is the case.
Say, I am a lender, and I want to lend to you (you issued a bond). Wouldn’t I want interest on the loan to be at least the same as the credit risk on your operations (assuming you are a company)?
If I am lending to you and receiving interest at a rate that is lower than the amount of risk in your firm’s cash flows, then why would it make sense to lend money to you?
Straight from the text: “This differential pricing can arise from mere differences of opinions, differences in models used by participants in the two markets, differences in liquidity in the two markets, and supply and demand conditions in the repo market, which is a primary source of financing for bond purchases.”
Everyone has different opinions on price… Thats why the market moves!
Not intuition: understanding.
Your question has nothing to do with the difference between the funding spread and the credit spread. What you want to understand is why the credit spread in the bond market is different from the credit spread in the CDS market.
That’s what 125mph just covered.
Seriously: you need to read the text on this stuff: the answers are there.
Ok, yeah I believe I understand it now.