CDS-bond Basis Research Articles

Sovereign debt and credit default swaps

How do credit default swaps (CDS) affect sovereign debt markets? We analyze how liquidity, exposure to default risk, and regulation affect the answer to this question using a sovereign debt model where investors trade bonds and CDS over the counter via directed search. Restricting portfolios can improve bond prices and bond-market activity, but the net effect depends on relative frictions in bond and CDS markets, the exposure of investors, and how the sovereign responds to the policy. Our novel identification strategy exploits confidential microdata to quantify trading frictions and the exposure distribution. The calibrated model generates realistic CDS-bond basis deviations, bid–ask spreads, and CDS volumes and positions. Our baseline specification predicts trading frictions and an inability to short sell bonds significantly improves sovereign debt prices, but policies that restrict CDS trading have small effects.

Sovereign Debt and Credit Default Swaps

How do credit default swaps (CDS) affect sovereign debt markets? The answer depends crucially on trading frictions, risk-sharing, arbitrage violations, and spillovers from secondary to primary markets. We propose a sovereign default model where investors trade bonds and CDS over the counter via directed search. CDS affect bond prices through several channels. First, CDS act as a synthetic bond. Second, CDS reduce bond-investing risks, allowing exposure to be unwound. Third, CDS availability increases trading profitability, which induces entry and reduces trading costs. Last, these direct effects feedback into default decisions. Our novel identification strategy exploits confidential microdata to quantify the extent of trading frictions and risk-sharing. The model generates realistic CDS-bond basis deviations, bid/ask spreads, and CDS volumes and positions. Our baseline specification predicts large effects of frictions generally but small spillovers from a naked CDS ban. These predictions hinge crucially on the identified parameters.

Bond Spreads and CDS-Bond Basis: Impact of Dodd-Frank Title VII

The tracheal isolation of Ureaplasma urealyticum from critically ill infants was investigated to determine if the organism was associated with an inflammatory response. Twenty nine neonates consecutively admitted for acute respiratory disease, with birthweights of < 1301 g and no evidence of viral, chlamydial, or bacterial infections, were identified. Culture results for ureaplasmas were correlated with white cell counts and clinical and radiographic features. Sixteen infants had tracheal aspirates and/or blood specimens positive for U urealyticum. Pneumonia was diagnosed more frequently in the U urealyticum positive infants than in the 13 who were negative for the organism. The mean total white cell count, absolute neutrophil, and band form counts were significantly higher in the U urealyticum positive group than in the negative group. These data suggest that U urealyticum can induce an inflammatory response in selected individuals who present with clinical, radiographic, and, in some instances, histological features of pneumonia.

The CDS-bond basis arbitrage in emerging markets: extreme sovereign risk

Financial markets, that are interconnected, have become more threatening to the economic world, especially when engaging in risky transactions. After the global financial crisis of the 2008-2009, massive investment funds with very short horizons flow to emerging market economy (EME). Since 2010, investors should face the illiquidity of the sovereign debt in this market. In order to understand the behavioural diversity of investors in emerging market (EM), this article focuses on the sovereign bonds and derivatives in emerging market during the European sovereign debt crisis and it aims to give an analysis of the influence of CDS-bond basis trade on the pricing of sovereign bonds. During the European sovereign debt crises (2010-2013), we will demonstrate that the liquidity situation of the emerging market sovereign bond is worsening. Our work is based on theoretical models of Brunnermeier and Pedersen (2009) that argue when the financial sector's funding liquidity and an asset's market liquidity risks join together, a liquidity spiral can develop.

The CDS-bond basis arbitrage in emerging markets: extreme sovereign risk

The CDS-bond basis arbitrage in emerging markets: extreme sovereign risk

Credit Default Swaps: A Primer and Some Recent Trends

The credit default swap (CDS) remains an important class of derivatives contract despite the declining activity in the single-name corporate market. I provide a quick introduction to the contracts, the pricing formula used to interpret the market premiums, the development in trading volumes, and some key insights that are important for understanding its role in markets. I then take a closer look at the CDS-bond basis and the role of trading and regulatory frictions. Finally, the European sovereign debt crisis brought back in focus the notion of a quanto spread, which I explain.

Disentangling types of liquidity and testing limits‐to‐arbitrage theories in the CDS–bond basis

AbstractWe disentangle asset‐specific, market, and funding liquidity in the CDS–bond basis outside and during the 2007–9 global financial crisis. Our findings stress the importance of separating different types of liquidity, since all three measures have independently negative impacts on the basis. Funding liquidity emerges as the economically most important liquidity metric. While asset‐specific liquidity is cross‐correlated in both the cash and derivative markets, funding and market liquidity only matter for the cash market. We exploit the decomposition of the basis to test predictions of limits‐to‐arbitrage theories. We find strong evidence in favor of margin‐based asset pricing and flight‐to‐quality effects.

Biases in CDS Spreads after the CDS Big Bang

The International Swaps and Derivatives Association (ISDA) credit default swap (CDS) standard model assumes a single flat hazard rate (default intensity) rather than a term structure of hazard rates. This assumption introduces biases into CDS spreads for empirical research after the CDS Big Bang. This article is the first to document the biases and provide a simple correction scheme. We quantify the biases using a large panel of CDS data for the period from April 2010 to October 2016. The correction is important for measures based on differences in CDS spreads, such as CDS-bond basis. <b>TOPICS:</b>Credit default swaps, credit risk management <b>Key Findings</b> • The flat hazard rate assumption in the International Swaps and Derivatives Association, Inc., credit default swap (CDS) standard model introduces biases into CDS spreads for empirical research after the CDS Big Bang. • We provide a simple correction scheme to address the biases. • The correction is important for measures based on differences in CDS spreads, such as CDS-bond basis.

Biases in CDS Spreads after the CDS Big Bang

The ISDA CDS standard model assumes a single flat hazard rate (default intensity) rather than a term structure of hazard rates. This assumption introduces biases into CDS spreads for empirical research after the CDS Big Bang. This paper is the first to document the biases and provide a simple correction scheme. We quantify the biases using a large panel of CDS data for the period from April 2010 to October 2016. The correction is important for measures based on differences in CDS spreads, such as CDS-bond basis.

The Corporate Supply of (Quasi) Safe Assets

Investors value safety services in financial assets, such as the ability to serve as a store of value, to serve as collateral, or to meet mandatory capital and liquidity requirements. I present a model in which investors value safety services not only in traditional safe assets such as US Treasuries, but also in corporate debt. Shareholders thus maximize the value of the firm by complementing standard business operations with safe asset creation. Based on this theoretical framework, I use the CDS-bond basis to derive a measurement of the safety premium of corporate bonds. I document substantial cross sectional variation in the safety premium of corporate bonds, which allows me to test the model's predictions. I show that a high safety premium leads to a marked increase in debt issuance by relatively safer firms. These debt proceeds have a small impact on real investment and are largely used instead for equity payouts. This mechanism can explain why, in the aftermath of the financial crisis, non-financial investment grade companies significantly increased their debt issuance and equity payout while investment remained weak.

Is Fed an Elephant or a Bellwether? The Impacts of SMCCF on US Corporate Bond Market

We study the impacts of Secondary Market Corporate Credit Facilities (SMCCF) on US corporate bond market. Using foreign “Yankee” bonds as a control group that are ineligible for direct purchase of SMCCF, we find that SMCCF significantly reduces the yield spreads of US bonds. However, the impacts differ by bond ratings and remaining maturity with safer bonds (AA/A-rated) and short-term bonds (remaining maturity less than 5 years) benefiting the most from SMCCF. We find that neither liquidity conditions nor credit risk profiles can account for the widened yield spread difference between US bonds and their foreign “Yankee” counterparts. SMCCF improves liquidity for both US bonds and “Yankee” bonds. The CDS-bond basis of US bonds, nonetheless, increases relative to the “Yankee” bonds. Although SMCCF does not run through the bond market like an elephant and more resembles a bellwether driving bond investors, our results indicate that the distorted notion of credit risk due to its purchase pledge and the weakened information efficiency in the bond market can be concerning.

The CDS-Bond Basis: Negativity Persistence and Limits to Arbitrage

We reinvestigate the CDS-bond basis negativity puzzle after the financial crisis. This puzzle is defined as the unexpected persistence of the dislocation between bond and derivative credit markets. We show that the first two moments of the basis are described by three distinct Markov regimes identified with periods related to the 2008 financial crisis. We observe that the post-crisis regime differs significantly from the crisis and the pre-crisis regimes. We then explore the cross-sectional variation of the CDS-bond basis in each regime. Using a model with several limit-to-arbitrage factors, we validate that the negative basis can be explained by liquidity risk in both the bond and CDS markets, together with counterparty risk, collateral quality, and funding constraints. Finally, we propose a model to empirically affirm that the basis negativity persistence during the post-crisis period is mainly related to a significant decrease in basis arbitrage activity, which is partly explained by the post-crisis regulatory reforms.

Analysis of CDS Spread Fluctuations with an Application to the Negative Basis Arbitrage

In this article, we first construct the empirical measure of spread (EMS) to capture the dynamics of quoted CDS spreads. It is the measure of creditworthiness of a company derived from the asset model in Egami and Kevkhishvili [2017]. We then use the information provided by the EMS to derive a refined negative CDS-bond basis trading strategy. Our contributions are twofold. By analyzing the period encompassing the global financial crisis, we find that the EMS is a forward-looking or leading indicator and can explain the movement of near future CDS spreads (20 or 30 days ahead). We then demonstrate that this feature of the EMS is present in non-crisis periods as well: therefore, the EMS could be used to predict future movement of CDS spreads. The second contribution is to improve efficiency in negative basis arbitrage trading. Specifically, we set up a finite-horizon optimal stopping problem for an investor who uses CDS contracts to hedge a long position in a zero-coupon bond. Using this problem, we provide a trading tool for the investor and show that the information obtained from the EMS can enhance the gain from negative CDS-bond basis arbitrage.

CDS-Bond Basis Dynamic and Credit Spread Price Discovery: A Test for European Corporate and Sovereign Bond Markets

This work analyzes the possible links between CDS premiums and bond spreads, with reference to both Eurozone sovereign and corporate markets, within the period 2011-2018. The main goal of this work is to provide more up-to-date results about the theoretical equivalence between the CDS premium and the credit spread of the underlying bond, and about the price discovery process of the credit risk between the CDS market and the bond market. While, theoretically, the CDS-bond basis must tend to zero, the analysis on all the considered markets has shown that it results to be constantly away from parity and, more specifically, positive on average. The analysis of the price discovery process of the credit risk between the CDS market and the bond market, analyzed by means of the VAR and VECM models, confirms the leader role of bond spreads for almost all the analyzed entities. These evidence could be useful for arbitrageurs, who want to take advantage of potential market inefficiencies, and for regulators interested in guaranteeing the financial system stability through timely and correct inclusion of all available information in the security prices, avoiding any adverse selection issue.

A novel approach for testing the parity relationship between CDS and credit spread

We test the CDS-credit spread arbitrage by taking into account the presence of an unobserved common factor structure driving the movement in the prices. We examine 193 European CDS-Bond basis from January 2007 to December 2009. We estimate one and two common factors for the corporate bond spreads and the CDS premia, respectively. We address the issue of cross-member cointegration by adopting a novel approach. While standard cointegration techniques support the parity relation, the novel approach discards this hypothesis.

Is Thailand’s credit default swap market linked to bond and stock markets? Evidence from the term structure of credit spreads

When the term structure of credit spreads is used in a panel vector autoregression model, Granger causality tests provide strong evidence of bi-directional relationships among CDS, bond and stock markets. This study argues that extant research using only a 5-year credit spread tends to understate intermarket linkages since in practice investors are able to trade credit risk over the entire term structure of credit spreads. Interestingly, this study produces new empirical evidence that the term structure of CDS-bond basis displays a monotonically increasing trajectory. As the maturity lengthens, the arbitrage opportunity of companies with negative (positive) CDS-bond basis decreases (increases).

Effect of U.S. Monetary Policy on Emerging Sovereign CDS-Bond Market

In a frictionless market, the CDS-bond basis, defined as CDS spread minus bond spread should be zero. I show that the emerging market CDS-bond basis systematically declines when US interest rates fall. The basis deviations are temporary and occur in both pre and post the financial crisis of 2008-09, although the effect is arguably stronger post crisis. The relationship is driven by a rise in investor demand to sell CDS when US rates are low and the investor motive is most consistent with reaching for yield. Aggregate outstanding sovereign CDS positions held by investors show net CDS sold increases when the rates fall. I also find the largest mutual funds in the emerging debt market are net sellers of CDS during 2006-2016 and show similar sensitivity to interest rates.

The CDS‐Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns

We provide a comprehensive empirical analysis on the implication of CDS‐Bond basis arbitrage for the pricing of corporate bonds. Basis arbitrageurs introduce new risks such as funding liquidity and counterparty risk into the corporate bond market, which was dominated by passive investors before the existence of credit default swap (CDS). We show that a basis factor, constructed as the return differential between LOW and HIGH quintile basis portfolios, is a superior empirical proxy that captures the new risks. In the cross section of investment grade bond returns, the basis factor carries an annual risk premium of about 3% in normal periods. © 2017 Wiley Periodicals, Inc. Jrl Fut Mark 37:836–861, 2017

Disentangling the Information Content of Government Bonds and Credit Default Swaps: An Empirical Analysis on Sovereigns and Banks

We propose a multi-factor Gaussian model to analyze the dynamics of sovereign bond yields, as well as sovereign and banks CDS quotes. This paper has three objectives (all of them with relevant implications from a supervisory perspective): (1) disentangling the credit risk component of sovereign bonds from the interest rate component; (2) exploring the sovereign CDS-bond basis, i.e. the di□erence between sovereign CDS quotes and the corresponding bond yields; (3) inferring from CDS quotes the idiosyncratic component of a bank credit risk and analyzing its relation with sovereign risk. We cast the model in a state-space form with linear measurement function. To calibrate the model we consider a maximum likelihood estimation together with a Kalman □lter method in which both the gradient vector and the Hessian matrix to be used in the optimization can be computed in closed form.

Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets

We find evidence that in the market for euro area sovereign credit risk, arbitrageurs engage in basis trades between credit default swap (CDS) and bond markets only when the CDS-bond basis exceeds a certain threshold. This threshold effect is likely to reflect costs that arbitrageurs face when implementing trading strategies, including transaction costs and costs associated with committing balance sheet space for such trades. Using a threshold vector error correction model, we endogenously estimate these unknown trading costs for basis trades in the market for euro area sovereign debt. During the euro sovereign credit crisis, we find very high transaction costs of around 190 basis points, compared to around 80 basis points before the crisis. Moreover, we find that once the threshold has been exceeded, the basis reverts back towards its long-run equilibrium substantially faster than when the basis is below the threshold. Our findings help explain the persistent non-zero basis or spread between credit risk premia in CDS and sovereign bond markets and suggest that the significant increase in the basis during the crisis was due to sharply higher costs facing arbitrageurs in the market, as well as compensation for increased risk that the trade would go against them in the short run.