Trading the bond-CDS basis: The role of credit risk and liquidity

Arbeitspapier

We analyze trading opportunities that arise from differences 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 difference 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-specific credit risk and liquidity, and to market conditions. In analyzing the aggregate profits of these basis trading strategies, we document that dissolving a position leads to significant profit variations, but that attractive risk-return characteristics still apply. The aggregate profits 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 profitable. Finally, we document the impact of the financial crisis on the profits of long and short basis trades, and show that the formerly more profitable long basis trades experienced stronger profit decreases than short basis trades.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: CFR working paper ; No. 09-16

Classification and Topics

• Classification: Wirtschaft ; Multiple or Simultaneous Equation Models: Cross-Sectional Models; Spatial Models; Treatment Effect Models; Quantile Regressions; Social Interaction Models ; Multiple or Simultaneous Equation Models: Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models ; Asset Pricing; Trading Volume; Bond Interest Rates ; Contingent Pricing; Futures Pricing; option pricing ; Information and Market Efficiency; Event Studies; Insider Trading ; Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
• Subject: bond asset swap spreads ; CDS premia ; basis trading profits ; credit risk ; liquidity ; fixed-effects ; vector error correction model ; Anleihe ; Credit Default Swap ; Wertpapierhandel ; Rentabilität ; Kreditrisiko ; Marktliquidität ; Fehlerkorrekturmodell ; Schätzung ; Schätzung ; Deutschland

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Trapp, Monika
• Event: Veröffentlichung
• (who): University of Cologne, Centre for Financial Research (CFR)
• (where): Cologne
• (when): 2009

Further information

• Handle: http://hdl.handle.net/10419/41361
• Last update: 10.03.2025, 11:45 AM CET