Uses of CDS

Investors exploit the arbitrage opportunities created by the differences in pricing between asset and CDS markets, or differences in pricing of different products in the market.

Credit Basis

A CDS basis is the difference between a bond’s credit spread and CDS spread. It arises from different opinions, relative market liquidity, model difference, and repo supply and demand.

• Positive basis: The credit basis is said to be positive if the spread in the CDS market is higher than the spread in the bond market. Here, the arbitrageur sells the bond and the CDS protection on the same name to benefit from the price differential resulting from the high CDS price and a low cash bond spread.
• Negative basis: The CDS basis is negative if the spread is higher in the bond market than in the CDS market. Here, the investor buys the bond and the CDS on the same reference name. He then realizes a profit if the basis declines.

CDS Indices

Arbitrage opportunities may arise if the cost of the CDS index is not equal to the aggregate cost of index components. An investor can exploit such an opportunity by going long on the cheaper instrument and short on the more expensive instrument.

For example, a synthetic CDO is created by combining default-free securities with CDS holdings. If an investor can assemble the synthetic CDO at a lower cost than the actual CDO, he/she can buy the former and sell the latter, exploiting a type of arbitrage profit.

Mispriced Instruments Issued by a Single Entity

Arbitrage opportunities may also arise when some of the unsecured debt instruments issued by an entity are incorrectly priced relative to the CDS. Investors can then buy the undervalued instruments and sell the overvalued ones. This eventually adjusts the market.

For example, in a leveraged buyout (LBO), a company issues a large amount of debt and repurchases all the publicly traded equity. Taking on the additional debt increases the probability of default, thereby increasing the CDS spread.

An investor who believes that a company will undergo an LBO might buy the stock and buy a CDS protection. The stock price rises, and the CDS price rises as its spread widen to reflect the increased probability of default. This implies that both the legs will increase in value.

Question

ABC’s 5-year corporate bond has a current yield of 10%, while a comparable CDS contract has a credit spread of 7.25%. LIBOR is 2.50%. An investor executes a basis trade by buying the bond and the CDS contract to exploit the bond and the CDS pricing. If there is a convergence between the bond and CDS markets, the trade will capture a profit closest to:

1. 0.25%.
2. 2.50%.
3. 4.75%.

Solution

The correct answer is A.

The basis trade strategy is based on the difference in credit spreads between the bond market and the CDS market.

$$ \begin{align*} \text{Bond credit spread} & = \text{Bond yield} – \text{Libor} \\   & =10\%-2.50\%= 7.5\% \end{align*} $$

The comparable CDS contract has a credit spread of 7.25%.

Therefore, the credit risk is cheap in the CDS market relative to the bond market. Since the protection and the bond were both purchased, trade convergence will capture the 0.25% (7.50% –7.25%) differential in the two markets.

Reading 32: Credit Default Swaps

LOS 32 (e) Describe the use of CDS to take advantage of valuation disparities among different markets, such as bonds, loans, equities, and equity-linked instruments.