The CDS‐bond basis

Abstract

We investigate the cross‐sectional variation in the credit default swap (CDS)‐bond bases and test explanations for the violation of the arbitrage relation between cash bond and CDS contract, which states that the basis should be zero in normal conditions. The evidence is consistent with “limits to arbitrage” theories in that deviations are larger for bonds with higher frictions as measured by trading liquidity, funding cost, counterparty risk, and collateral quality. Surprisingly, we find the basis to be more negative when bond lending fee is higher suggesting that arbitrageurs are unwilling to engage in a negative basis trade when short interest on the bond is high.

Municipal Bond Liquidity and Default Risk

“…Oehmke and Zawadowski () provide a model in which a bond‐CDS basis emerges due to the higher cost of trading bonds. Bai and Collin‐Dufresne () provide empirical evidence that the basis is large for bonds with higher frictions…”

Evaluating the impact of unconventional monetary policy measures: Empirical evidence from the ECB׳s Securities Markets Programme

“…We overcome the respective estimation challenges by fixing ν = 4 and allowing for time-varying volatility in the factor innovation terms. 13 In theory, arbitrage ensures that the CDS-bond basis should be close to zero (Bai and Collin-Dufresne, 2013). In practice, arbitrage is risky and requires capital whose availability depends also on market conditions (Brunnermeier and Pedersen, 2009).…”

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

“…Moreover, Arora et al () show that counterparty risk is priced in CDS market. Bai and Collin‐Dufresne () aim to explain the basis level by their constructs of funding liquidity measure, counterparty risk measure, liquidity, and collateral risk measure and find that these proxies can explain up to 50% of the total basis in time series but less than 25% in cross sections.…”

“…Duffie () generalizes that slow‐moving capital is a pervasive market friction over time and across different asset classes. Bai and Collin‐Dufresne () show that funding liquidity risk, counterparty risk, and collateral quality jointly determine the basis level. Nashikkar, Subrahmanyam, and Mahanti () find that some determinants of the basis are related to a bond's accessibility, liquidity, and probably short‐sale constraints faced by bond investors.…”