Trading the Basis
There are several ways in which valuations in the cash markets are ■ linked to those in the synthetic markets. One straightforward way is simply a reference point. Suppose an investor wanted to take exposure to the high-yield bond market, for example. Moreover, suppose the investor could earn a spread of 1,500 basis points by buying a broad portfolio of cash bonds, or a spread of 500 basis points via the a credit default swap index (CDX.HY). Where is the incremental dollar going to be allocated?
Incremental capital will probably be deployed in the cash market, working to compress the valuation difference between the two. Or the investor may be inclined to take an even more aggressive position and establish a basis package; that is, the investor would go long high-yield cash bonds combined with a short CDX.HY position. This more aggressive position will have a more dramatic impact on compressing relative valuations.
In general, basis packages are the purchase (or sale) of specific exposure in the cash market and the simultaneous sale (or purchase) of the same risk in the synthetic market, ideally at two different prices.
Theoretically, assets with a similar risk profile should move more-or-less in tandem in the cash and synthetic markets (e.g., bonds and credit default swaps for the same company). But they do not at all times. In this chapter, we discuss reasons why, and how to take advantage. We begin by providing a basic template for market participants ...