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Trading the bond-CDS basis: The role of credit risk and liquidity

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  • Trapp, Monika
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    Abstract

    We analyze trading opportunities that arise from differences between the bond and the CDS market. By simultaneously entering a position in a CDS contract and the underlying bond, traders can build a default-risk free position that allows them to repeatedly earn the difference between the bond asset swap spread and the CDS, known as the basis. We show that the basis size is closely related to measures of company-specific credit risk and liquidity, and to market conditions. In analyzing the aggregate profits of these basis trading strategies, we document that dissolving a position leads to significant profit variations, but that attractive risk-return characteristics still apply. The aggregate profits depend on the credit risk, liquidity, and market measures even more strongly than the basis itself, and we show which conditions make long and short basis trades more profitable. Finally, we document the impact of the financial crisis on the profits of long and short basis trades, and show that the formerly more profitable long basis trades experienced stronger profit decreases than short basis trades. --

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    Bibliographic Info

    Paper provided by University of Cologne, Centre for Financial Research (CFR) in its series CFR Working Papers with number 09-16.

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    Date of creation: 2009
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    Handle: RePEc:zbw:cfrwps:0916

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    Related research

    Keywords: bond asset swap spreads; CDS premia; basis trading profits; credit risk; liquidity; fixed-effects; vector error correction model;

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    Cited by:
    1. Óscar Arce & Sergio Mayordomo & Juan Ignacio Peña, 2012. "Credit-Risk Valuation in the Sovereign CDS and Bonds Markets: Evidence from the Euro Area Crisis," Faculty Working Papers 22/12, School of Economics and Business Administration, University of Navarra.
    2. : Haitao Li & Weina Zhang & Gi H. Kim, 2011. "The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns," Working Papers wpn11-04, Warwick Business School, Finance Group.

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