Abstract - Trading the Bond-CDS Basis - The Role of Credit Risk and Liquidity

We analyze trading opportunities that arise from diff erences between the bond and the CDS market. By simultaneously entering a position in a CDS contract and the underlying bond, traders can build a default-risk free position that allows them to repeatedly earn the diff erence between the bond asset swap spread and the CDS, known as the basis. We show that the basis size is closely related to measures of company-specifi c credit risk and liquidity, and to market conditions. In analyzing the aggregate profi ts of these basis trading strategies, we document that dissolving a position leads to signi cant profi t variations, but that attractive risk-return characteristics still apply. The aggregate profi ts depend on the credit risk, liquidity, and market measures even more strongly than the basis itself, and we show which conditions make long and short basis trades more pro fitable. Finally, we document the impact of the fi nancial crisis on the profi ts of long and short basis trades, and show that the formerly more profi table long basis trades experienced more drastic profi t decreases than short basis trades.

Monika Trapp
Universität zu Köln
01.Feb 2011

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