@talebi818 that's correct, in the "no aribtrage" (no basis trade or carry = 0), the bond yields +5% but it costs -2% to fund the purchase of the bond; i.e., naked bond = +3% net spread. Then investor hedges default by purchasing CDS at cost of 3% which brings carry to zero. So: +5 bond spread - 2% borrowing - 3% CDS = 0.
Normally basis is defined as the diference between rates in cash market minus those in derivative market. Then why is CDS basis = CDS spread - Z spread (derivative market - cash market)
thank you for this explanation....there's one gap in my understanding though. as an investor, why would one enter a positive scenario? i imagine the whole incentive for purchasing a bond is to have net positive cash flow from the interest. buying protection for more than the bond interest seems counter-intuitive...can you please help me understand the incentive for the investor in this scenario? thx
Why did you say “counterparty risk” instead of credit risk? There is no counterparty (or pre-settlement) risks in that deal, only credit to the CDS-selling body.
The "investor" (who purchased the credit protection; aka, long CDS) incurs counterparty risk exposure to the credit protection seller (aka, CDS seller, short CDS) per what I tried to say here ru-vid.com/video/%D0%B2%D0%B8%D0%B4%D0%B5%D0%BE-D4s8IWPJwG0.html
David, not sure if you're around to answer this but...Is it safe to say that the neg or pos basis trades, due to market forces converging on arbitrage opportunities, do not last long in these cases? In other words, in practice are basis trade difficult to achieve?
Hello George. If you do not receive an answer from David here, I would suggest visiting our forum where David and other members answer questions daily. Please just make sure to reference this video if you are asking a specific question about it. Here is the link to our forum: www.bionicturtle.com/forum/. Nicole Bionic Turtle
Dumb question but have to ask. Why is the bond deemed cheap and CDS deemed expensive for a negative basis trade? Answers probably staring me in the face, but I'll swap ego for knowledge everytime.
Hi, Don't know whether my understanding is 💯 percent right. But I can share my understanding. In a negative basis trade, CDS spread is lower than bond spread i.e actual return on investment in CDS will be less when compared to bond. Hence we can say yield for CDS is less in comparison in bond which implies CDS is expensive compared to bond. Hope I was helpful. Do keep me posted if you have read the answer.
