Trading the CDS Basis

Abstract

Excerpted by permission from “The Credit Default Swap Basis” (c)2006 Bloomberg Press. A basis exists in any market where cash and derivative forms of the same asset are traded. Given that the derivative represents the cash asset in underlying form, there is a close relationship between the two 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 a more recent market, that of credit derivatives. The logic behind the no-arbitrage theory of pricing credit default swaps 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 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 article, we describe trading the basis, with real-world examples given of such trades, illustrating the positive basis trade and the negative basis trade.