The CDS Basis

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Credit Default Swap, Asset Swap Spread, Basis

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The CDS Basis

  1. 1. The CDS Basis
  2. 2. General • The CDS basis is the difference between the CDS spread and the asset swap spread (ASW) of the same reference asset • Put it another way, it is the difference between the synthetic market (CDS) and the cash market (ASW) • In theory there should be no difference. • This presentation gives a brief overview on why the difference exists and what are the main causes
  3. 3. Basics: Long/Short Position Short CDS • A short position in the CDS market means that you are selling credit protection, i.e. you think the quality of the underling asset is improving Long CDS • A long position in the CDS markets means you are buying protection, i.e. you think the quality of the underlying asset is worsening “Long the underlying asset” “Short the underlying asset”
  4. 4. Calculation of the Basis The basis is given by: CDS Spread ASW Spread- Basis= • There are a number of reasons why the difference exists • Broadly speaking it‘s because the CDS market trades credit separately from any other factors
  5. 5. Risk Factors included • The ASW includes funding risk • The CDS contains only credit risk ASW CDS • Credit risk • Funding risk • Credit risk
  6. 6. Negative/Positive Basis Basis is positiveCDS Spread ASW Spread> Basis is negativeCDS Spread ASW Spread< • Positive Basis: CDS trades higher • Negative Basis: CDS trades tighter = =
  7. 7. Driving Factors of the Basis • CDS premiums are above zero • Bond trades below/above par • Market liquidity improves/worsens • Counterparty risk improves/worsen • Demand and supply • Model inputs • Macroeconomic distortions
  8. 8. Finale Note • Do not put too much faith in CDS spreads • In order to come up with a spread certain assumptions have to be made • Bond market yields are usually a better indicator • When you look at sovereign debt watch for the 6% threshold on the 10y bond • History shows hardly any country can survive above this level for a long time (without a bailout) when the debt to GDP ratio is about 90%

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