Hey Guys!
I have confusion on the basis trade topic in derivates. I just cant understand that logic between that of a bond and CDS…if we have a bond with coupon 7% and LIBOR 2.5% and CDS is priced at 4.25% …how are we earning .25% profit. (i understand that Bond priced at 4.50% (7-2.5) and difference is .25% between CDS and Bond) But what is the logic behind going long on both and how are getting the profit in practical terms.
Thanks
Can you provide more details or where you are seeing this in the text? I am not sure what you are referencing but I think you mean the bond is trading at par (YTM of 7%) and the CDS is priced at 4.25% then you would be making a risk free profit of 25 bps by going long both of them and here is how.
Purchase the bond at a YTM of 7% and also purchase CDS protection at 4.25%. Therefore you have 0 credit risk - it is complete hedged. You are earning 7% on the underlying bond and paying 4.25% to hedge out your credit risk through the CDS. Therefore you are left with a spread of 2.75% on this trade when the risk free rate represented by LIBOR is 2.50%. Therefore the riskless profit is the 25 bps.
I believe this is what you are getting at.
You got my point. Thanks!