Tim Olson
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56 lines
3.0 KiB
Markdown
56 lines
3.0 KiB
Markdown
---
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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."
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tags: [fixed-income, arbitrage, cds, credit-spread, basis]
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---
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# CDS Basis Arbitrage
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**Section**: 5.14 | **Asset Class**: Fixed Income | **Type**: Arbitrage / Credit
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## Overview
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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.
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## Construction / Mechanics
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**CDS basis**:
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```
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CDS basis = CDS spread - bond spread (417)
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```
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where bond spread = bond yield - risk-free rate.
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**Arbitrage logic**:
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- CDS spread should ≈ bond spread (both represent compensation for default risk)
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- If CDS basis ≠ 0 (and |basis| exceeds transaction costs), an arbitrage opportunity exists
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**Negative basis trade** (most common):
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- CDS basis < 0: bond spread > CDS spread → bond is relatively cheap
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- Trade: **buy the bond** (receive the high spread) + **buy CDS protection** (pay the lower CDS spread)
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- Net P&L per dollar of insured debt: bond spread - CDS spread = -basis > 0
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- Result: a nearly risk-free positive carry, since the CDS makes the bond effectively risk-free
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**Positive basis trade** (less common in practice):
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- CDS basis > 0: CDS spread > bond spread → CDS protection is expensive relative to bond
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- Trade: sell the bond + sell CDS protection (write CDS)
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- In practice, this often means unwinding an existing position (already owning both the bond and CDS)
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## Payoff / Return Profile
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- Earns the absolute value of the CDS basis as a near-riskless spread.
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- Position closed when basis converges back to zero.
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- The trade is essentially a carry trade: positive carry from the basis for as long as it persists.
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## Key Parameters / Signals
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- CDS basis = CDS spread - bond spread: the primary signal
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- Transaction cost threshold: |basis| must exceed bid-ask spreads and financing costs
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- Sign of basis: negative → buy bond + buy CDS; positive → sell bond + sell CDS
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## Variations
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- **Synthetic bond replication**: CDS + risk-free bond (e.g., Treasury repo) replicates a corporate bond; mispricing between the two creates the arbitrage.
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## Notes
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- CDS protection makes the bond synthetically risk-free, but counterparty risk on the CDS remains.
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- Negative basis arbitrage requires financing the bond purchase (repo market); the repo rate affects net P&L.
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- 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.
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- Liquidity risk: corporate bonds may be illiquid, making it difficult to close the position at fair value.
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- In the positive basis case, selling a corporate bond short is operationally challenging.
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