My client has tasked me with implementing CDS basis functionality for the traders, so I thought I would jot down what is required.
The CDS basis is defined as the CDS Spread minus the Asset Swap Spread/Z Spread - the result is usually positive, although this is not always the case.
If the basis is sufficiently positive, a trader could enter into the following trades:
- Borrow and sell the underlying bond (easier said than done), investing the proceeds of the short position.
- Sell protection on the reference entity
The CDS fee would be greater than the spread on the asset swap leading to a profit
Conversely if the basis is sufficiently negative, the trader could
- Purchase the underlying bond (by repo or money market borrowings)
- Purchase CDS protection.
The spread on the asset swap is greater than the payment for CDS protection, so again a profit is made
There are several things that drive the basis, including
Positive basis:
- Credit events: All CDS contracts with restructuring types except XR (no restructuring) would be triggered by a restructuring credit event
Negative basis:
- Counterparty risk: The protection buyer runs the risk that the protection seller will not/can not pay up when the reference entity defaults.
To look at CDS basis on Bloomberg, type in the corporate ticker, the coupon and the maturity. Next tap the "Corporate" key and "CRVD". Shown below is British American Tobacco.
The following screen will then be shown
Here we can see that there are five reference bonds, and the basis is negative.
The programmatic side isn't too difficult either.
Firstly, we must work out which bonds relate to a given entity. My client is fortunate enough to have access to Markit, so can use the reference red obligations to look up the underlying bonds. Once we have these ISIN's we can look up the Bloomberg IssuerID. From here we can look up all bonds with the same issuerID, tier and currency as the cds we are looking at.
Next, we must find the CDS spread value, which is the five year spread minus the interpolated spread value.
Taking the first bond (02/25/09) as an example, we would do the following
- Calculate time to maturity
= Maturity - next roll date
= 25/02/2009 - 20/09/2006 = 2.4 years
- Calculate spread at term above and below
Assuming 2 year spread is 9 bps and 3 year is 14 bps, this would give
9 + (((2.4 - 2)/(3-2))* (14 - 9))
=11 bps
= 11-17
=-6bps
References:
Pages 459-488
Chapter 11
Chapter 8
Choudry has another book out soon on CDS basis
http://www.amazon.co.uk/gp/product/1576602362/ref=wl_it_dp/026-8787779-9446068?ie=UTF8&coliid=I2UP6EDODZ3A89&colid=187F0UOF8NJGT