CHAPTER 10

Trading the Credit Default Swap Basis: Illustrating Positive and Negative Basis Arbitrage Trades

A basis exists in any market where cash and derivative forms of the same asset are traded. For example, there is a crude oil basis. Given that a derivative instrument such as a credit default swap (CDS) represents the cash asset in underlying form, there is a close relationship between the two asset types, which manifests itself in the basis and its magnitude. Fluctuations in the basis give rise to arbitrage trading opportunities between the two forms of the asset. This has proved the case in the more recent market of credit derivatives.1

In Chapter 8 we summarised the logic behind the no-arbitrage theory of pricing CDS, which suggests that the premium of a CDS should be equal to an asset swap (ASW) spread for the same reference name. There are a number of reasons why this is not the case however,2 and in practice a non-zero basis exists for all reference names in the credit markets. The existence of a non-zero basis implies potential arbitrage gains that can be made if trading in both the cash and derivatives markets simultaneously. In this chapter we describe trading the basis, with real-world examples given of such trades, illustrating the positive basis trade and one the negative basis trade.

RELATIVE VALUE AND TRADING THE BASIS

The introduction of credit derivatives into the financial markets has provided a new asset class for investors in credit-risky assets. That ...