can breakdown, the relative value default swap trade seeks to exploit
these opportunities. There are two ways of exploiting this difference the
first is the long basis trade in which the investor buys the assets and
simultaneously buys protection. The converse is a short basis trade in
which the investor sells the asset and simultaneously sells protection.
Long basis trade
There are a number of ways of going along the basis for a particular
credit, the choice to a certain extent will depend on the types of instru-
ments the borrower has issued into the market. We begin with an analy-
sis of a basis trade which is carried out by purchasing a par FRN and
protection. This will illustrate the relationship between the spread on
the floater and the default protection premium. From Figure 3.20 we
can see that the default spread is equal to the asset swap spread when
the asset is at par.
Buying protection
If an investor wishes to be immunized against the default of the issuer
there are a number of assumptions which must be considered prior to
constructing the hedge. It is not a simple case of sourcing protection,
but rather the details depend on the nature of the underlying asset.
We consider the case of a common example; an asset swap on a vanilla
bond. (The motivation and arrangement of this have been discussed in
some depth within Section 3.8.)
Credit derivatives 163
Hedged investor
Protection seller
Borrows 100 Libor
Default swap spread
Pays 100
L spread
Figure 3.20 The risk free basis trade. Source: Lehman.

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