---
description: "CDS basis arbitrage exploits the mispricing between a bond's credit spread and its CDS spread — when the CDS basis is negative (bond spread too high), buy the bond and buy CDS protection to lock in a risk-free profit."
tags: [fixed-income, arbitrage, cds, credit-spread, basis]
---

# CDS Basis Arbitrage

**Section**: 5.14 | **Asset Class**: Fixed Income | **Type**: Arbitrage / Credit

## Overview
A credit default swap (CDS) provides insurance against default on a bond. In theory, the CDS spread should equal the bond yield spread over the risk-free rate, making the insured bond equivalent to a risk-free instrument. The CDS basis is the difference between these two spreads, and deviations from zero create arbitrage opportunities.

## Construction / Mechanics

**CDS basis**:
```
CDS basis = CDS spread - bond spread                                 (417)
```

where bond spread = bond yield - risk-free rate.

**Arbitrage logic**:
- CDS spread should ≈ bond spread (both represent compensation for default risk)
- If CDS basis ≠ 0 (and |basis| exceeds transaction costs), an arbitrage opportunity exists

**Negative basis trade** (most common):
- CDS basis < 0: bond spread > CDS spread → bond is relatively cheap
- Trade: **buy the bond** (receive the high spread) + **buy CDS protection** (pay the lower CDS spread)
- Net P&L per dollar of insured debt: bond spread - CDS spread = -basis > 0
- Result: a nearly risk-free positive carry, since the CDS makes the bond effectively risk-free

**Positive basis trade** (less common in practice):
- CDS basis > 0: CDS spread > bond spread → CDS protection is expensive relative to bond
- Trade: sell the bond + sell CDS protection (write CDS)
- In practice, this often means unwinding an existing position (already owning both the bond and CDS)

## Payoff / Return Profile
- Earns the absolute value of the CDS basis as a near-riskless spread.
- Position closed when basis converges back to zero.
- The trade is essentially a carry trade: positive carry from the basis for as long as it persists.

## Key Parameters / Signals
- CDS basis = CDS spread - bond spread: the primary signal
- Transaction cost threshold: |basis| must exceed bid-ask spreads and financing costs
- Sign of basis: negative → buy bond + buy CDS; positive → sell bond + sell CDS

## Variations
- **Synthetic bond replication**: CDS + risk-free bond (e.g., Treasury repo) replicates a corporate bond; mispricing between the two creates the arbitrage.

## Notes
- CDS protection makes the bond synthetically risk-free, but counterparty risk on the CDS remains.
- Negative basis arbitrage requires financing the bond purchase (repo market); the repo rate affects net P&L.
- The CDS basis can persist or widen during stress periods (e.g., 2008 financial crisis) before eventually converging, creating significant mark-to-market losses in the interim.
- Liquidity risk: corporate bonds may be illiquid, making it difficult to close the position at fair value.
- In the positive basis case, selling a corporate bond short is operationally challenging.