Development of CDS-Bond Basis - Assignment Example

CDS-BOND Development of CDS-Bond Basis CDS is the agreement between buyer and seller which exchange the credit risk, which is called “reference entity”. CDS is the most common credit derivatives in bond market. The function of CDS is to protect the bond default. The CDS buyer is paying a protection fee to seller, which is called “a premium”. If there are losses occurring in credit event, the buyers would be compensated by seller. Normally, the protection to buyers includes the failure of reference entity, bankruptcy, repudiation, etc. This would be similar to buy insurance to protect them. However, it is different with those financial insurance in the market because it is not a must to have financial stake in the reference entity. Due to assumption, there should not exist any arbitrage opportunity. However, there are a lot of risky factors and imperfect market in the world. A bond on the whole can also be said to be an instrument of indebtedness that a holder receives from a bond issuer as a security, based on which interest is paid to the holder at an agreed maturity date (quote). In principle therefore, quote (year) sees a CDS and a bond serving almost the same purpose, a reason for which CDS is generally said to be utilised on the bond market. In reality however, the two cannot be said to be exactly the same, as CDS deals with credit risk whiles bonds deals with the real debt and not just the risk that comes with it (quote). Because of the differences in the realities of using either CDS or a bond, particularly corporate bond, quote (year) observed that there are some in relative quantitative terms when a single entity decided to choose the two forms of derivatives to serve different purposes on the bond market. With this said, quote (year) notes that when all variables of market engagements such as principal and duration are the same, it is expected that the resulting benefits will be same for a typical CDS and corporate bond. However, this has not always been the case, due to issues of mispricing (quote). It is for such purposes of mispricing that leverage in the form of CDS-bond basis may be necessary to absorb major differences. Based on the preamble given above, quote (year) explained that the difference between the Credit Default Swap (CDS) and the bond spread (Or the difference between the CDS premium and the bond credit spread) is called “CDS-bond basis”. Based on assumption of prefect market, CDS and bond spreads are priced for the same underlying credit risk, which also mean the CDS-Bond Basis is the difference (either positive or negative) between risky bond and risk free rate (S= y - r). As mentioned before, we assume the market is ideal, which is also meant risk natural, and there exist three assets, risky bond, risk free bond and CDS contract. As a basis of the ideal market concept, quote (year) noted that the difference that arises from a CDS-bond basis happens as an indicator of mispricing. The determinants of the basis or mispricing consist of several factors including counterparty risk, liquidity, financial cost, and risk premiums (quote). Quote (year) would however classify these factors as residual basis that cannot be explained among a wide array of risk factors but only given as a measure of arbitrage opportunities. This means that the arbitrage of CDS-bond basis could be introduced to improve the market efficiency. This is because the arbitrage opportunities when identified as part of the residual basis could be deemed as factors that must be controlled in order to avoid the mispricing. In effect, knowledge of the arbitrage of CDS-bond basis comes as a means by which the ideal market that has already been mentioned can be achieved. Once this ideal market is achieved, it can be said that market efficiency has been improved (quote). Historical Perspective of CDS-bond basis Given the relationship between credit default swaps (CDS) and corporate bond in defining CBS-bond basis, it is always relevant that in giving the historical perspective of CBS-bond basis, the history behind the two concepts be clearly outlined. In this, quote (year) explained that CDS had been in existence since the early 1990s but in many different forms than they are known to be today. For example in 1991, Bankers Trust was known to have carried out some of the earliest forms of CDS but their approach was widely considered unorthodox and therefore remain undocumented in most economic and finance literature (quote). It was therefore not until 1994 that J.P Morgan & Co. began what may be considered the modern form of CDS when credit risk to the tune of $4.8 billion to Exxon was sold to the European Bank of Reconstruction and Development (quote). Corporate bond on the other hand is known to have been in place several years before CDS, when corporations raised long-term debt instruments for the purposes of securing the financing of both internal and external business operations (quote). Getting to the middle of the 1990s however, the concept of CDS-bond basis would be popular with the growth of CDS-bond products in the European and US financial markets. Many financial firms concerned the credit risk and credit derivatives in order to improve risk management. The basis of the assertion made above is that CDS-bond basis was necessitated among financial firms for the reason of achieving the combined benefits of CDS and corporate bonds in a single financing transaction (quote). This is because CDS-bond basis has already been explained to be the difference recorded as indicator of mispricing between CDS and corporate bonds (quote). In its earliest forms and entering into the 2000s, CDS-bond products were known to be used in baking, hedge funds, mutual funds. It has a significant effect in trading volume and liquidity (quote). Originally, the biggest market players came from commercial banks. They traded as over-the-counter transactions within the bankers. They tried to hedge the risk against credit activities. As the market was dominated by commercial bankers, more and more investors such as hedge fund and asset management companies went into the CDS market. From 1996 to 2002, the market dominators changed from bankers to hedgers and the size of CDS market got a rapidly increase. Besides the above factors enhanced the growth of the market, some unexpected factor such Asian Crisis in 1997 would stimulate the market growth. As the result, the market had a rapid growth until 2007. In 2008, serious negative CDS-bond basis existed because of financial crisis. This slowed down the activities of most notably market players but quote (year) observes that the situation could not lead to the total collapse of the concept as it seemed to have resurrected massively with the improvement in global economy since 2010. Reference to market data Market data of CDS-Bond mainly came from two sources which are International Swaps and Derivatives Association (ISDA), and the Bank of International Settlements. The above Associations provide annual and semi-annual data of CDS-bond basis. In addition, The Depository Trust & Clearing Corporation provides weekly-based information but the most updated information do not punish publicly. The data given by the Corporation only provide the data which goes back one year. As the data provided by different authorities, the data would have unmatched information due to different data modeling methods, for example, co-integration test. All CDS information is observed over a period of time, usually 2 years. Only some of the senior CDS are required over 3-year, 5-year or 10-year tenor. Mostly, 5-year maturity of CDS bond is chosen because the liquidity is the best, compared with other maturity. Problem of analysing and modelling the CDS-Bond Basis In the analysis and modelling of CDS-bond basis, quote (year) noted that it is important to have a common measure that serves as the basis for the cash or bond. In the commonest context of financial market engagements, it is very common to find that this is being done with the use of sovereign asset swap spreads. These sovereign asset swaps are the financial instruments that go in exchange for the cash flow from the security that is being traded (quote). It is generally known that par asset swap is a typical example of sovereign asset swap, where the buyer purchases a bond from a seller with the agreement that there will be a full price of par paid in return (quote). Until such a time that the bond matures, the buyer continues to pay a fixed interest to the seller, getting the buyer exposed to credit risk in a situation where defaulting occurs by the issuer on any future interest or the principal (quote). By implication, there could be a core problem with the analysis and modelling of the CDS-bond basis, knowing that issuer default could be experienced at any point with future payments. It was for this reason that quote (year) argued that any modelling or estimation that is done for CDS-bond is based on assumption that all expected variables will hold unchanged. In such a situation as given above, four major variables are often considered to make the asset swap spread estimation used by O’Kane (2000) to be valid in analysing and modelling the CDS-bond basis. These variables are bond price and interest, the reference rate, the discount factor, and the basis. Using these four variables, the following equation was produced by O’Kane (2000) for a fixed value A. From the equation, O’Kane (2000) explained that P is the full price of the bond, while C is the bond coupon or interest. L1 is the floating reference rate, with the t1 being the time and d(t1) being the discount factor applied to the time. Even though the stated equation above has been used extensively to find the asset swap which is subsequently used to model or estimate the CDS-bond basis, there are some problems that have been noted to come with this, which has the potential of affecting the overall analysis and modelling of CDS-bond basis. The first of these has been found to be the difficulty in finding bonds that are outstanding with maturities which match the CDS contracts in an exact manner (quote). Because of this, even though there is a generalised premise that bond price and coupon are used as variables, it is virtually not possible to get this in its most accurate value. What is more, quote (year) saw that in a typical bond market, the cash-flows of the bonds and the CDS which are used as two independent instruments may not coincide, causing more complications when undertaking comparison between the two, which are CDS and corporate bond. This problem confirms earlier claims made about the fact that the real outcomes with CDS-bond basis represent the mispricing that took place. This is because this problem reveals that the mispricing could occur partly due to the differences between cash-flow of the bonds and the CDS. Last but not least, quote (year) stressed that in the use of asset swap and other forms of methodologies in constructing CDS-bond basis, one critical problem that may arise is the justification of the predictability of corporate bond returns, whether these are manipulated by risks or mispricing. Read More