The Credit Default Swap Basis II: Analysing the Relationship Between Cash and Synthetic Markets

The rapid growth of the credit derivative market has produced a liquid market in CDS across the credit curve. This liquidity in turn has helped to generate further growth in the market. For a large number of corporate and certain sovereign names the liquidity of the credit derivative market frequently exceeds that available for the same reference names in the cash market.1 It is this feature that enabled fund managers to exploit their knowledge of credit trading by originating synthetic CDO vehicles, which enabled them to arbitrage between cash and synthetic markets. These products were at the centre of the credit crunch and liquidity crisis during 2007–2009, and the market in them dried up almost completely. The basic CDS contract remained liquid, and as well as greater liquidity, the synthetic market also still offers investors the opportunity to access any part of the credit term structure, and not just those parts of the term structure where corporate borrowers have issued cash market paper. The liquidity of the synthetic market has resulted in many investors accessing both the credit derivative and the cash bond markets to meet their investment requirements. The synthetic market also offers other potential advantages to investors who would generally consider only the cash markets. For illustration, we list some potential advantages in Table 9.1 on page 294, which builds ...

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