The Negative CDS-bond Basis and Convergence Trading During the 2007/09 Financial Crisis
60 Pages Posted: 9 Oct 2010 Last revised: 22 Sep 2011
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The Negative CDS-Bond Basis and Convergence Trading During the 2007/09 Financial Crisis
Date Written: September 1, 2011
Abstract
This paper studies the CDS-bond basis, i.e. a measure of price discrepancies between CDS and bonds spreads, for a sample of investment-graded US firms. Results show that during the 2007/09 financial crisis the basis was time varying and negatively correlated to: the “Libor-OIS” spread, a proxy for the increased funding cost and risk in the interbank lending market, to measures of “bond value uncertainty,” which proxy for the increase in “haircuts” and to the “OIS-Tbill” spread, a proxy for the “flight-to-liquidity” and its related liquidity premium. Moreover, large losses erased the capital used to fund margin requirements and forced convergence traders to close their positions prematurely, thus amplifying large shocks.
Keywords: CDS; bond spread, funding liquidity, repurchase agreement, convergence trading, financial crisis
JEL Classification: G01, G12
Suggested Citation: Suggested Citation
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