The Cash-CDS Basis for Sovereign Countries : Market Strategy, Price Discovery and Determinants

In this paper we study the cash-CDS basis and its implication in terms of market strategy and price discovery, while we investigate the role of credit risk common factors as determinants. After a description of CDS and asset swap contracts, we present the strategy: a positive net income is derived with a negative cash-CDS basis, once funding costs for both asset swap and CDS are considered. An example is offered for Greece in 2010: there exists an arbitrage opportunity in a limited period (end of April up to 7 May), where the cash-CDS basis is negative by more than 100 bp. Our comparison with three different basis shows interesting results: when these basis converge, markets seem adopt the same strategy. This is true in particular for Portugal, Ireland and Greece. When we investigate for price discovery, data show that the CDS market moves ahead the bond market, even if for some countries this relation is not clear. Finally, our empirical analysis on basis determinants shows that: i) the global risk factor iTraxx Europe contributes to increase the basis; ii) the markets' risk aversion does not offer a direct contribution, while iii) the banking sector vulnerability proxy offers a negative contribution, in particular for Ireland