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

  • Alessandro Fontana

    ()

    (Department of Economics, University Of Venice Cà Foscari)

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.

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File URL: http://www.unive.it/media/allegato/DIP/Economia/Working_papers/Working_papers_2010/WP_DSE_fontana_13_10.pdf
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Paper provided by Department of Economics, University of Venice "Ca' Foscari" in its series Working Papers with number 2010_13.

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Length: 40
Date of creation: 2010
Date of revision:
Handle: RePEc:ven:wpaper:2010_13
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Web page: http://www.unive.it/dip.economia
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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.
  3. Edwin J. Elton, 2001. "Explaining the Rate Spread on Corporate Bonds," Journal of Finance, American Finance Association, vol. 56(1), pages 247-277, 02.
  4. Gonzalo, Jesus & Granger, Clive W J, 1995. "Estimation of Common Long-Memory Components in Cointegrated Systems," Journal of Business & Economic Statistics, American Statistical Association, vol. 13(1), pages 27-35, January.
  5. Roberto Blanco & Simon Brennan & Ian W. Marsh, 2005. "An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps," Journal of Finance, American Finance Association, vol. 60(5), pages 2255-2281, October.
  6. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March.
  7. Lee, Tae-Hwy & Tse, Yiuman, 1996. "Cointegration tests with conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 73(2), pages 401-410, August.
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