I think Schweser might be contradicting CFAI on this one. Schweser says on pg 328: “If it (a bond’s asset swap spread over LIBOR) is higher than the CDS premium, the basis is negative and, to exploit the arbitrage opportunity, the investor should BUY THE BOND AND BUY THE CDS.” CFAI says on pg 317: “An example of this strategy is to buy a 5 yr British American Tobacco bond at LIBOR plus 60 bps and SHORT 5 YR CDS AT 46 BPS, resulting in a negative-basis package of 14 bps.” So, Schweser says go long on both if the basis is negative, and CFAI says go long on the bond and short the CDS. Anyone see a flaw in my reasoning to believe Schweser is wrong?
I have an idea of what you’re getting wrong but please wait for confirmation as this is just a hunch. I think both CFAI and Schweser are right, but Schweser presents it more simply. The idea is to buy the bond and buy the CDS. So if the bond returns 150 basis points and the CDS returns 130 basis points, you are netting 20 basis points and have gotten rid of your credit risk. But if you buy a CDS, what are you actually doing? You are going short. When goldman sachs wants credit protection from aig on a bond on say GM, they are short GM (they have bearish views on it), so they are short gm i.e. they buy a CDS on GM bonds. So short = buy cds = both schweser and cfai are right.
CDS premium - asset swap spread CDS ASS “The basis of my negativity is to shove that CDS up your ass”
the show NY Wrote: ------------------------------------------------------- > I have an idea of what you’re getting wrong but > please wait for confirmation as this is just a > hunch. > > I think both CFAI and Schweser are right, but > Schweser presents it more simply. The idea is to > buy the bond and buy the CDS. So if the bond > returns 150 basis points and the CDS returns 130 > basis points, you are netting 20 basis points and > have gotten rid of your credit risk. > > But if you buy a CDS, what are you actually doing? > You are going short. When goldman sachs wants > credit protection from aig on a bond on say GM, > they are short GM (they have bearish views on it), > so they are short gm i.e. they buy a CDS on GM > bonds. > > > So short = buy cds = both schweser and cfai are > right. I see what you’re saying. Are we just suppose to assume then that when they say “short” a CDS, they don’t mean sell it like the term “short” applies everywhere else, they actually mean buy a CDS because you are bearish on the firm? Can we get another confirmation?
A CDS is just a contract you enter into. Being the short end of the contract means you’ll collect payments from the long. You don’t short the CDS, you enter into the short position.
but that conflicts with what CFAI says? I remember newsuper addressed this http://www.analystforum.com/phorums/read.php?12,943267,944958#msg-944958
So, as clarification… ya’ll are saying the person that is “buying the insurance” in the CDS is the Short position? Seems odd to put it that way, especially considering that you pay a premium up front. Right?
Where are the frigging financial engineers when you need them? wyantjs, where are you buddy?
Hey guys, got confused with those CDS as well… will be devastated if we get a vignette on it … M.
CF_AHHHHHHHHH Wrote: ------------------------------------------------------- > So, as clarification… ya’ll are saying the > person that is “buying the insurance” in the CDS > is the Short position? Seems odd to put it that > way, especially considering that you pay a premium > up front. Right? Yep, if you buy the insurance you’re short the CDS (you benefit if the company the CDS is based on defaults) The seller of the insurance is long the CDS. I think just take it as mentioned above: a basis trade = you go long a bond and buy insurance on the bond (going short on the CDS)
Whoa whoa whoa. The buyer of protection is short the credit (credit being a synonym for bond). The buyer is long the CDS (which is a contract that is worth more if a default occurs) The seller of a CDS is long the credit (again, the underlying bond) and short the CDS contract (expects that premiums received will be greater than payouts required).
^ yeah sorry, that is what I’m trying to say but your explanation is clearer about you being short the credit (not the CDS itself per se)
DC Zanini Wrote: ------------------------------------------------------- > Schweser says on pg 328: > > “If it (a bond’s asset swap spread over LIBOR) is > higher than the CDS premium, the basis is negative > and, to exploit the arbitrage opportunity, the > investor should BUY THE BOND AND BUY THE CDS.” > > CFAI says on pg 317: > > “An example of this strategy is to buy a 5 yr > British American Tobacco bond at LIBOR plus 60 bps > and SHORT 5 YR CDS AT 46 BPS, resulting in a > negative-basis package of 14 bps.” i do see a discrepancy, but the way i see it, a person who buys a CDS pays a fixed rate and receives protection in return. in this negative basis trade, if the CFAI is saying to go long the bond, this means that we will receive 60 bips and pay 46 bips, thus earnings 14 bips. considering this, wouldn’t we be long the CDS?
dlpicket Wrote: ------------------------------------------------------- > Whoa whoa whoa. > > The buyer of protection is short the credit > (credit being a synonym for bond). The buyer is > long the CDS (which is a contract that is worth > more if a default occurs) > > The seller of a CDS is long the credit (again, the > underlying bond) and short the CDS contract > (expects that premiums received will be greater > than payouts required). makes sense but then it conflicts with the cfai quote from the first post above.
Crap… gotta run to a meeting. I’m going to ask some of the bond traders I work with about this. I’m not going to argue with CFAI on exam day, but I’m 99% sure the way we talk about it here, is just how I stated above.
http://www.bmocm.com/products/marketrisk/credit/trades/default.aspx i wish they said if they were long / short the CDS. otherwise a very good description.
It says “The investor then buys credit protection via a CDS.” So it looks like he is long the bond and long the CDS (i.e. bearish on the underlying, short the underlying." I hate to say it but CFAI seems incorrect. Is it worth contacting them about this? Or is CPK around?
niraj_a Wrote: ------------------------------------------------------- > http://www.bmocm.com/products/marketrisk/credit/tr > ades/default.aspx > > i wish they said if they were long / short the > CDS. otherwise a very good description. That is a good description. It says for a negative basis trade, “The investor then buys credit protection via a CDS to hedge the credit risk of the bond issuer.” I would assume that means they are Long the CDS. Now, I’m thinking of a CDS sort of like a put option. When you’re long on a put option, you own it and it protects your long position in the stock should the share price go down. Or, you bought the put for speculation purposes and are bearish on the stock. Same thing with a CDS right? You Long (buy) a CDS to protect your asset swap long position should the credit quality of the firm decline. Or, you bought the CDS for speculation purposes and are bearish on the credit quality of the firm. It seems to me like CFAI is wrong, but I’d be interested to hear what dlpicket’s bond trader friends have to say about it. Or, we can say F it and hope it doesn’t show up on the exam!
I agree CFAI is wrong ERRATA!!!
I’ll see if I can figure out how to report it to CFAI