Trading Basis Part 1

Abstract

The Credit Default Swap (CDS) market is still fairly young. As a result, there are some areas that have not yet been fully investigated. One of those areas is the behavior of the Cheapest to Deliver Option (CTD) embedded within the CDS contract. Fluctuations in the CTD translate into changes in the ?Basis?, the visible difference between the credit spread of a bond and its CDS. The aim of this paper is to develop a trading strategy that profits from fluctuations in the value of the CTD. To do this, we try to shed some light on the factors affecting the CTD within Emerging Markets (EM) Sovereigns Bonds. We propose a stylized closed-form Black-Scholes framework that identifies those factors which are likely to be most important. We run statistical tests to verify the validity of this approach and develop a Monte Carlo simulation model to put a value on the CTD. We find that the statistical tests give credence to the Black-Scholes formulation and are corroborated by the implications of the Monte Carlo model. The resulting trading strategy is highly profitable. We also discuss some potentially important ancillary results, relating to a method for obtaining the implied market values for both bond default probabilities and recovery rates.