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The Persistent Negative Cds-Bond Basis during the 2007/08 Financial Crisis

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  • Alessandro Fontana

    () (Department of Economics, University Of Venice C� Foscari)

Abstract

I study the behaviour of the CDS-bond basis - the difference between the CDS and the bond spread - for a sample of investment-graded US firms. I document that, since the onset of the 2007/08 financial crisis it has become persistently negative, and I investigate the role played by the cost of trading the basis and its underlying risks. To exploit the negative basis an arbitrageur must finance the purchase of the underlying bond and buy protection. The idea is that, during the crisis, because of the funding liquidity shortage and the increased risk in the financial sector, which exposes protection buyers to counter-party risk, the negative basis trade is risky. In fact, I find that basis dynamics is driven by economic variables that are proxies for funding liquidity (cost of capital and hair cuts), credit markets liquidity and risk in the inter-bank lending market such as the Libor-OIS spread, the VIX, bid-asks spreads and the OIS-T-Bill spread. Results support the evidence that during stress times asset prices depart form frictionless ideals due to funding liquidity risk faced by financial intermediaries and investors; hence, deviations from parity do not imply presence of arbitrage opportunities.

Suggested Citation

  • Alessandro Fontana, 2010. "The Persistent Negative Cds-Bond Basis during the 2007/08 Financial Crisis," Working Papers 2010_13, Department of Economics, University of Venice "Ca' Foscari".
  • Handle: RePEc:ven:wpaper:2010_13
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    References listed on IDEAS

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    1. Francis A. Longstaff & Sanjay Mithal & Eric Neis, 2005. "Corporate Yield Spreads: Default Risk or Liquidity? New Evidence from the Credit Default Swap Market," Journal of Finance, American Finance Association, vol. 60(5), pages 2213-2253, October.
    2. Houweling, Patrick & Vorst, Ton, 2005. "Pricing default swaps: Empirical evidence," Journal of International Money and Finance, Elsevier, vol. 24(8), pages 1200-1225, December.
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    5. Engle, Robert & Granger, Clive, 2015. "Co-integration and error correction: Representation, estimation, and testing," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 39(3), pages 106-135.
    6. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, February.
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    Citations

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    Cited by:

    1. Balduzzi, Pierluigi & Brancati, Emanuele & Schiantarelli, Fabio, 2013. "Financial Markets, Banks' Cost of Funding, and Firms' Decisions: Lessons from Two Crises," IZA Discussion Papers 7872, Institute for the Study of Labor (IZA).
    2. repec:wly:jfutmk:v:37:y:2017:i:8:p:836-861 is not listed on IDEAS
    3. : Haitao Li & Gi H. Kim & Weina Zhang, 2010. "The CDS-Bond Basis and the Cross Section of Corporate Bond Returns," Working Papers wpn10-03, Warwick Business School, Finance Group.
    4. Mamatzakis, Emmanuel & Tsionas, Mike G., 2015. "How are market preferences shaped? The case of sovereign debt of stressed euro-area countries," Journal of Banking & Finance, Elsevier, vol. 61(C), pages 106-116.
    5. Gi H. Kim & Haitao Li & Weina Zhang, 2017. "The CDS‐Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 37(8), pages 836-861, August.
    6. Alessandro Carboni, 2011. "The sovereign credit default swap market: price discovery, volumes and links with banks' risk premia," Temi di discussione (Economic working papers) 821, Bank of Italy, Economic Research and International Relations Area.
    7. Gianfranco Gianfelice & Giuseppe Marotta & Costanza Torricelli, 2015. "A liquidity risk index as a regulatory tool for systemically important banks? An empirical assessment across two financial crises," Applied Economics, Taylor & Francis Journals, vol. 47(2), pages 129-147, January.
    8. repec:wsi:gcrxxx:v:02:y:2012:i:01:n:s2010493612500055 is not listed on IDEAS
    9. Emmanuel Mamatzakis & Panos Remoundos, 2012. "What are the Driving Factors Behind the Rise of Spreads and CDS of Eurozone Sovereign Bonds? A Panel VAR Analysis," Global Credit Review (GCR), World Scientific Publishing Co. Pte. Ltd., vol. 2(01), pages 79-94.

    More about this item

    Keywords

    CDS; bond spread; funding rate; liquidity risk; counterparty risk; financial crisis.;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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