CDS basis trade
general idea is to arbitrage on mispricing of these assets is this works the other way round?
How about if credit spread is higher than underlying bond credit spread is this imply that we should sell protection and sell short bond?
R
Hi rafal,
Let us assume that basis spread = CDS Spread - Corporate Bond Spread. Corporate Bond Spread could be equal to the yield on the bond - some reference yield (ie 10 Year Treasury Yield or 10 Year Swap Spread).
The premise is that basis spread should be ZERO (to prevent arbitrager); and if you think about it, it should be zero (JUST IN THEORY, in reality, because both instrucments have different type of risk (such as counterparty risk/market risk/operational risk)) , because the risk premium rate that you get paid to hold the CDS note should be the same risk premium to hold the Corporate Bond on top of the risk-free treasury rate.
If the basis is POSITIVE, then CDS spread is too high (or the bond spread is too low). And what does CDS spread is too high mean? That means market participants THINK that the risk (or probability) of a credit event occurence is higher than it ACTUALLY will happen. But to prevent this arbitrage, the CDS spread will revert (or drop), and as you say in the OP, you would sell protection because the actual risk of holding the CDS is lower, and the CDS spread will drop. Sell High and Buy Low. Standard Sale Philosophy. What about the Corporate Bond Spread? The spread (or yield) will go up (again, to prevent arbitrage). And what happen to the price of bond when yield goes up? That’s Fixed Income 101: Yield Up, Price Down; Yield Down, Price Up. And hence you short sell the bond if you expect the yield to go up.
For negative basis trade, you just reverse the logic of what I just explained.
Hope this helps.