Schweser Book 5 page 328 talks about a CDS basis trade where if the basis is negative (swap spread < CDS premium) then the strategy is to buy the bond and buy the CDS. Shouldn’t it be buy the bond and short the CDS?
actually I see now that by buying the CDS you are ‘short’ the bond and make a profit on the difference in ‘cost’ of the two sides of the trade
Let’s not forget that that the basis is negative if the swap spread is higher than the CDS premium
AliMan is right, its negative when bond spread > Cds spread. So you will receieve a higher spread when you buy the bond and when you buy the CDS you’llpay a smaller spread. Keep in mind that buying CDS is buying insurance.
the downside to basis trades is that it requires financing since you are long both the CDS premium and the bond, correct?
sounds correct to me
newsuper, I just read CFAI on this because I realized I actually don’t understand it, and they say a guy goes long a bond and then shorts the relevant CDS for a spread. I also thought that swap spreads applied to fixed interest rates to treasury securities with the same maturity, so it’s an indication of credit risk?
Yeah I also had to read the CFAI text as well, but it didn’t make it any clearer for me. I’m pretty certain that a negative basis trade involves buying both the bond and the CDS, which would mean that you would need to finance both the bond and the CDS. I found this explanation here, which is a little bit more than we need (they describe a swap in addition to the basis trade), but it seems correct to me: http://www.bmocm.com/products/marketrisk/credit/trades/default.aspx Negatives Basis Trades Credit default swaps (CDS) are not just a hedging tool for bank loan portfolio managers - CDS are being used by bond investors to create unique relative value investment strategies. In particular, investors are discovering that the relationship between CDS prices and asset-swapped bond spreads can periodically offer attractive arbitrage opportunities. The difference between a bond’s asset swap spread and CDS premium (i.e. cost of purchasing credit protection) is referred to as the CDS basis. If the CDS premium is less than the asset-swapped bond spread, the basis is described as negative. Here is how a negative basis trade typically works: * An investor buys a cash bond. If it is a fixed rate bond, the investor asset swaps the bond to earn a base floating rate of interest (such as BA’s) plus a fixed spread. The asset swap allows the investor to gain exposure to the bond’s credit risk while minimizing any interest rate risk. * The investor then buys credit protection via a CDS to hedge the credit risk of the bond issuer. If the bond issuer experiences a credit event (typically specified as bankruptcy, failure to pay, or restructuring) during the life of the credit default swap, the investor can deliver the bond to the CDS counterparty (BMO) for payment at par. * The net return to the investor will be the asset-swapped floating rate earned on the bond minus the cost of the CDS. The investor has effectively replaced his credit exposure to the bond issuer with counterparty risk to BMO under the interest rate and credit default swaps, i.e. the investor is exposed to BMO in the event the bond issuer defaults.
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Makes so much more sense! Thank you!!