{"id":21793,"date":"2021-09-29T06:38:43","date_gmt":"2021-09-29T06:38:43","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=21793"},"modified":"2026-05-08T10:16:03","modified_gmt":"2026-05-08T10:16:03","slug":"uses-of-cds","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/uses-of-cds\/","title":{"rendered":"Uses of CDS"},"content":{"rendered":"<p><script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"ABC\u2019s 5-year corporate bond has a current yield of 10%, a comparable CDS spread of 7.25%, and LIBOR is 2.50%. If an investor executes a basis trade by buying the bond and CDS contract, what profit is most likely captured if the markets converge?\",\n    \"text\": \"ABC\u2019s 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 CDS pricing. If there is a convergence between the bond and CDS markets, the trade will capture a profit closest to:\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"0.25%\"\n    },\n    \"suggestedAnswer\": [\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"0.25%\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"2.50%\"\n      },\n      {\n        \"@type\": \"Answer\",\n        \"text\": \"4.75%\"\n      }\n    ]\n  }\n}\n<\/script><\/p>\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/rtmE95_MpsQ\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<p>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.<\/p>\n<h2>Credit Basis<\/h2>\n<p>A <em><strong>CDS basis<\/strong><\/em> is the difference between a bond&#8217;s credit spread and CDS spread. It arises from different opinions, relative market liquidity, model difference, and repo supply and demand.<\/p>\n<ul type=\"a\">\n<li><strong><em>Positive basis:<\/em> <\/strong>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.<\/li>\n<li><em><strong>Negative basis: <\/strong><\/em>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.<\/li>\n<\/ul>\n<div style=\"text-align: center; margin: 24px 0;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 10px 24px; border: 1.5px solid #1a73e8; border-radius: 999px; color: #1a73e8; text-decoration: none; font-weight: 600;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"> Practice CDS basis trades and credit derivative strategies with a Free Trial. <\/a><\/div>\n<h2>CDS Indices<\/h2>\n<p>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.<\/p>\n<p>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.<\/p>\n<h2>Mispriced Instruments Issued by a Single Entity<\/h2>\n<p>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.<\/p>\n<p>For example, in a <em><strong>leveraged buyout<\/strong><\/em> (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.<\/p>\n<p>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.<\/p>\n<blockquote>\n<h2>Question<\/h2>\n<p>ABC&#8217;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 <em>closest to<\/em>:<\/p>\n<ol type=\"A\">\n<li>0.25%.<\/li>\n<li>2.50%.<\/li>\n<li>4.75%.<\/li>\n<\/ol>\n<h4>Solution<\/h4>\n<p><strong>The correct answer is A.<\/strong><\/p>\n<p>The basis trade strategy is based on the difference in credit spreads between the bond market and the CDS market.<\/p>\n<p>$$ \\begin{align*} \\text{Bond credit spread} &amp; = \\text{Bond yield} \u2013 \\text{Libor} \\\\\u00a0 \u00a0&amp; =10\\%-2.50\\%= 7.5\\% \\end{align*} $$<\/p>\n<p>The comparable CDS contract has a credit spread of 7.25%.<\/p>\n<p>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% \u20137.25%) differential in the two markets.<\/p>\n<\/blockquote>\n<p>Reading 32: Credit Default Swaps<\/p>\n<p><em>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.<\/em><\/p>\n\n            <div \n                class=\"elfsight-widget-pricing-table elfsight-widget\" \n                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\n                data-elfsight-pricing-table-version=\"2.6.1\"\n                data-elfsight-widget-id=\"elfsight-pricing-table-3\">\n            <\/div>\n            \n<div style=\"text-align: center; margin: 40px 0 24px; padding: 28px 20px; border: 1px solid #e5e7eb; border-radius: 14px; background: #f9fafb;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 30px; border-radius: 999px; background: #1a73e8; color: #ffffff; text-decoration: none; font-weight: bold;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"> Start Free Trial \u2192 <\/a><\/p>\n<p style=\"margin: 16px auto 0; font-size: 16px; line-height: 1.6; max-width: 720px;\">Strengthen your understanding of CDS basis trades, credit spread relationships, CDS indices, and CFA Level II credit derivative applications with AnalystPrep\u2019s practice-focused study resources.<\/p>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>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&#8217;s credit spread and&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,472],"tags":[216,548],"class_list":["post-21793","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-fixed-income","tag-cfa-level-2","tag-fixed-income","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.4 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Uses of CDS - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Learn about positive and negative CDS basis, CDS indices arbitrage, and leveraging mispriced instruments for profit.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/uses-of-cds\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Uses of CDS - 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