I am confused about the implications of a positive/negative basis in the CDS market. While the chain of transactions in order to price the CDS (S[CDS] = Sc-Ss-Sr) is clear, I do not understand the logic behind the reaons for a positive/negative basis. Schweser (LO7.22, p34) says about the conditions for a negtive basis: Excess protection selling tightens the CDS swap spread. More specifically: - Relative illiquidity of the cash market may drive protection sellers to accept smaller spreads in order to trade in a more liquid market. (How will the protection seller hedge his own risk in an illiquid market though? Would he not want a higher CDS spread as illiquid markets are more risky?) - If plain vanilla bonds are not available, then bond with options must be used. The protection seller may be willing to accept lower premiums to isolate pure credit risk. (Again: if optionable bonds must be used, would the seller not want a higher spread?) - If the borrowing cost of the margial protection seller (=?) is significantly above LIBOR, the spread will narrow. - Excess supply from structured products that sell protection to fund promised coupons. (This is clear: oversuplly will narrow spreads). Any help most welcome!
You have to think these from the CDS seller’s point of view. Remember, he can (a) sell a CDS or (b) create the same effect in the cash market with repo & swap. Illiquidity refers to cash market. He’d rather do (a) even at a lower spread since (b) is illiquid. The same goes for plain vanilla bonds. Again, he’ll rather do (a) and accept a lower spread than go for (b) which includes other risks (callable bonds etc). Borrowing cost comes from the formula. If Sr goes up, S[CDS] goes down. In other words, alternative (b) yields him less so in equilibrium, he also accepts less from (a).
Many thanks!