Credit Risk: From Transaction to Portfolio Management

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

Asset

Funding

Protection seller

Borrows 100 Libor

Default swap spread

Pays 100

L  spread

Figure 3.20 The risk free basis trade. Source: Lehman.