Credit Derivative Strategies: Basis Trades selling, question, protection, 361, buying

lunarfollies

Reading 65, page 361.

"An example of this strategy is to buy a five-year British American Tobacco bond at LIBOR plus 60 bps and short a five-year CDS at 46 bps, resulting in a negative-basis of 14 bps"

This isn't sinking in correctly for me. We are long the BAT bond, so wouldn't we want to be protection buyers (ie. buying a CDS?). This question has us Long the BAT bond, and acting as protection sellers (ie. selling a CDS) and the result is a negative basis package of 14 bps.

My logic is:

Long bond @ LIBOR + 60 bps
Sell CDS @ 46 bps

Thus we are increasing our yield. Obviously I'm missing something.

Matt

xilige

We earn LIBOR+60bps on the bond. We sell protection and collect a premium of 46bps. So we have not covered our 60bps exposure completely, so there is a negative basis of the difference of 14bps. If we sell protection at 65 bps then we have positive basis of 5.

Make sense? maybe? I hope. Correct me if I'm wrong or find another example of this.

5566

The above trade does not make sense as it is not riskless arbitrage

You cant short CDS (sell protection) and long bond at the same time because if the bond defaults then you have to pay the (Par-market) to protection buyer and you will end up poor.

The trade should be
long bond and receieve 60 bps
long CDS (buy protection) and pay 46bps

Resulting in negative basis trade to earn you 14bps

Think CDS premium - asset spread = negative basis = profit of 14bps = good thing

From your example sell cds and buy bond = 40+64 = 104 bps income, which will be washed pretty quickly when the bond defaults

huangxiaoxie

thanks nomad! So basically if you own a bond you're always going to buy protection (long CDS)?

giorgio10

That is my understanding of buying protection. When you own a bond you have the risk of default and to protect yourself from that risk you buy protection.

brainsX

right, thanks