1

The Opacity of the CDS Basis

Gaetan Lion

March 30, 2012

2

Why is this an important topic?

3

CDS is a huge Business

Nominal CDS contract outstanding exceeds World GNP.

4

Two CDS Buyers have made a huge

amount of money Michael Burry, the “one eyed

surgeon”, will create the first

CDS on Subprime CDOs with

Greg Lippman from Deutsche

Bank in 2005. Dr. Burry will

make $100 million for himself

and about $700 million for his

clients.

John Paulson enters this CDS on

Subprime CDOs market in 2006. He

will make $7 billion for himself and $23

billion for his hedge fund clients.

5

Several CDS Sellers have lost a huge

amount

Also, European banks who invested in Synthetic CDOs

were by definition CDS sellers. They were the ones on the

other side of the trades who lost money to Michael Berry

and John Paulson.

6

CDS is a great source of Credit Risk

Information

Very Different Credit Risk for major US Banks.

7

People are focusing on the CDS Basis

CDS Basis = CDS premium – Bond Credit Spread.

8

Some Institutions have incurred large

losses on CDS Basis trades

In early 2009, Merril Lynch, Deutsche Bank and

several hedge funds did lose several $billions on

CDS basis trade commonly known as Negative Basis

trade*.

*When the CDS premium is lower than the Bond

spread, a trader buys the Bond (ie. Credit Spread

4%) and buys the CDS (pays premium 3%) and earns

a spread (1%) between the two… ideally anyway?!

9

CDS & CDS Basis Introduction

10

CDS intro The CDS buyer (the

insured) pays a credit

insurance premium on

a specific bond issuer,

covering the latter’s

credit risk for the

duration of the CDS

contract.

The CDS seller

sells credit

insurance against

the default of a

specific bond issuer

and receives a

premium from the

CDS buyer.

If the bond issuer

defaults, the CDS

seller (the insurer)

repays the CDS

buyer the par value

of the bond.

11

A CDS is a Put Option on the Bond Par value CDS Buyer pays a premium and "Puts" the Bond back to the Buyer in case of default.

CDS

value

positive

+

0% Repayment prob. or (1 - Default prob.) 100%

CDS Seller receives premium and repays Bond par value to the Buyer in case of default.

CDS

value

positive

+

0% Repayment prob. or (1 - Default prob.) 100%

CDS

value

negative

-

Premium

12

Change in Default Probability impacts

CDS value

When the Default probability

increases, the CDS value

rises and the CDS Buyer’s

Put is in the money. He can

resell it at a profit.

CDS Buyer pays a premium and "Puts" the Bond back to the Buyer in case of default.

Incr. in Default prob. Decrease in Default prob.

CDS

value

positive

+

0% Repayment prob. or (1 - Default prob.) 100%

CDS

value

negative

-

CDS Seller receives premium and repays Bond par value to the Buyer in case of default.

CDS Incr. in Default prob. Decrease in Default prob.

value

positive

+

0% Repayment prob. or (1 - Default prob.) 100%

CDS

value

negative

-

Premium

13

CDS Basis

CDS Basis = CDS premium – Bond Spread over Rfr.

In theory, under the no-arbitrage principle, the CDS

Basis would equal zero. In reality, the CDS Basis is

always away from zero, either positive or negative.

Positive Basis: CDS > Bond Spread

Negative Basis: CDS < Bond Spread

14

Choices of Bond Spreads

That’s when

it gets foggy

(opaque)

15

Clarity vs Opacity

Clarity: A CDS quote is crystal clear. The

premium is expressed in basis points per

annum.

Opacity: the Bond spread is calculated. And,

there are several underlying issues.

1) What is the appropriate discount rate (Rfr)?

2) What is the appropriate Spread calculations?

Different Spread calculations can result in the

CDS Basis changing sign!

16

The Evolution of Bond Spread Calculations

1 Bond Spread: Bond Yield - Treasuries of same term.

2 Bond Spread: Bond Yield - Treasuries tax adjusted

Adjustment for Treasuries being State tax exempt.

3 Asset Swap Spread (ASW): Asset Swap Rate - LIBOR

Disaggregates Credit Risk from Interest Rate Risk.

Takes into account the term structure of interest rates.

4 Z-Spread or Zero Coupon Spread.

Uses Treasuries instead of LIBOR to construct term structure of interest rates.

5 I-Spread or Interpolated Spread.

Uses interpolated Treasury rates. A variation of the Z-Spread.

6 Option Adjusted Spread (OAS)

Takes into account the term structure of probabilities of default by

constructing a survival probability curve.

Legend

Not the main Spread established benchmark anymore.

Currently most common ones. Quoted on Bloomberg.

17

Bond Spread vs ASW, Z-Spread, I-Spread

Difference in Spread Calculation

0%

2%

4%

6%

8%

10%

12%

1 2 3 4 5Period 3Period 1 Period 2Constant rate

Rfr

Rfr1

Rfr2

Rfr3

Credit

Spread

Bond Spread ASW, Z-Spread, and I-Spread

Within the Bond Spread method, cash flows are discounted at the same rate.

Within the other Spreads, cash flows discounting reflects the term structure of

interest rates. Notice that the Credit Spread component is constant within either

method. That’s even though the derived Credit Spread may be different.

18

Bond Spread vs OAS Difference in Spread Calculation

0%

2%

4%

6%

8%

10%

12%

14%

1 2 3 4 5Period 3Period 1 Period 2Constant rate

Rfr

Rfr1

Rfr2

Rfr3

Credit

Spread

(CS)

Bond Spread

OAS

CS1

CS2

CS3

The Option Adjusted Spread (OAS) method of discounting captures

both the term structure of interest rates and credit risk or defaults. They

are low in Period 1 and continue rising in all future periods. The OAS is

the Credit Spread that corresponds to the discounted PV weighted of all

the various Credit Spreads (CS1, CS2, CS3, etc…).

19

The Asset Swap Spread

An Investor invests in a fixed rate bond paying 7%. To hedge his interest

rate risk, he enters into an Interest Rate Swap with a counterparty and

passes on the 7% fixed rate payment in exchange for floating rate

LIBOR + 3%. The 3% is the Asset Swap Spread (ASW).

PV of 7% fixed rate payments = PV LIBOR + 3% payments

7%

Fixed rate 7% Bd. Investor I.R. Swap

bond Counterparty

LIBOR + 3% (ASW)

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Asset Swap with a CDS

7%

Fixed rate 7% Bd. Investor I.R. Swap

bond CDS Buyer Counterparty

CDS premium

3%

CDS

Seller

LIBOR + 3% (ASW)

The Bond Investor has already hedged his interest rate risk. He now

wants to hedge his credit risk. He buys a CDS on the bond issuer and

pays a CDS Seller a premium.

Now, we can define the CDS Basis: CDS premium – ASW.

In this case it is zero. Net result, Investor earns Libor.

21

Asset Swap with CDS at Default

7%

Bd. Investor I.R. Swap

CDS Buyer Counterparty

CDS

Seller

LIBOR + 3% (ASW)

pays Bd

Par value

Puts

Bonds

Bond issuer.

Ch 11 or 7:

Reorg./

Liquidation

Puts

Bonds

Recovery

Note that for the initial Bond Investor the Interest Rate Swap is still going on!

He can unwind that swap, but he is now exposed to a mark-to-market risk on

this IR swap. While the Bond issuer was solvent, the Bond Investor’s interest

rate risk was hedged. But, upon default it is not.

22

Factors affecting the CDS Basis

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Basic Economic Principles

Any factor increasing the risk of a CDS Seller relative to the

ASW will increase the CDS basis (and vice versa).

Any factor increasing the return of a CDS Seller relative to

the ASW will decrease the CDS basis (and vice versa).

Any factor boosting the Demand for CDS (Seller side)

relative to the ASW will increase the CDS basis (and vice

versa).

Any factor boosting the Supply for CDS (Seller side) relative

to the ASW will decrease the CDS basis (and vice versa).

Those concepts of Risk, Return, Demand, Supply are

universal and affect all insurance products (car insurance,

etc…).

24

Some Factors affecting the CDS Basis

• Change in interest rates (+ or -);

• Funding considerations (+ or -);

• Relative liquidity (bid & ask spread) in both markets (+ or -);

• Synthetic CDO Issuance, Loan syndication, etc…: It boosts Seller Supply (-);

• Relative counterparty risk considerations (CDS Seller credit quality vs Interest Rate Swap counterparty risk);

• Difficulty in shorting bonds: when CDS basis > 0, arbitrage of selling the CDS and selling the bond is rarely feasible (+).

• CDS credit event trigger definition is often broader than for the Bond. It increases the CDS Seller risk (+).

25

Change in Interest Rates

1. At time of default, the loss of the CDS Seller is equal to Par value of the bond minus recovery. The loss of bondholder is Market value of the bond minus recovery. If interest rates have risen:

Market value < Par value; and

CDS loss > Bondholder loss.

And, vice versa. This affects the CDS basis accordingly.

2. Change in interest rates also affect the mark-to-market value of the embedded interest rate swap within the asset swap structure (ASW). Remember, the interest rate swap survives after default!

3. Change in Repo rates affects ability to short a bond. But, it is really difficult to short a bond anyway.

26

Funding Considerations

When you invest in the Credit risk of a

company by purchasing a bond you pay

money. If you invest in Credit risk by selling a

CDS you actually receive money (premium).

Thus, changing capital market conditions affect

CDS and Bonds differently.

27

An Arbitrage Opportunity Decision Tree

Major Fog

Warning

28

The Basic Decision Tree

You can’t rely on just the Asset Swap Spread (ASW) or its

equivalents (Z-Spread, I-Spread). You have to look at the

Option Adjusted Spread (OAS).

CDS > OAS No arbitrage

CDS < ASW

CDS < OAS Negative basis trade: buy Bond & buy CDS

CDS > OAS No arbitrage

CDS > ASW

CDS < OAS Negative basis trade: buy Bond & buy CDS

29

The OAS Decision Tree

> Bid & Ask Spreads Negative basis trade

[CDS < OAS]

< Bid & Ask Spreads No arbitrage

The absolute value of the CDS negative basis has to be

greater than related Bid & Ask spreads. Otherwise, the

transaction costs eliminate the arbitrage opportunity.

30

Opacity?!

The mentioned factors are the ones affecting the CDS Basis

described earlier. Several are qualitative in nature and

challenging to predict and quantify precisely. It is uncertain

whether such OAS models can provide reliable information.

This questions the viability of arbitrage opportunities.

[CDS < OAS]>Bid-Ask Arbitrage opportunity

or disaster?

OAS Model underestimated factors Negative basis trade loses money

[CDS < OAS]>Bid-Ask

OAS Model got it right Negative basis trade is profitable

31

Appendix Section

32

Working Papers Findings

Working papers analyzing the CDS Basis (using mainly the I-Spread as proxy for Bond Spread) through various time periods from January 1999 through December 2005 have found the following:

1) CDS Basis: the Average CDS basis is very small and typically positive (ranging from – 2 bp to 16 bp). The Median is even smaller (0 to 7 bp). The CDS Basis can depend on time, place (US vs Europe), and company.

2) Price discovery: using sophisticated methods* they found that at times CDS tend to lead bonds spreads. It is more so in the US, and less so in Europe.

*Cointegration, Granger Causality, VECM methods.

33

Morgan Stanley CDS vs Bond Spread

Between 8/31 and 11/24/2011 the Bond Spread (Bond Yield – Treasury) has been

much higher than the CDS. For other time periods, the reverse may have been

observable.

34

CDS always lead in both the decline and increase in credit risk until

convergence in early 2010.

35

As the title suggests, Italian bond spreads take the lead in May 2011.

36 Here Spain CDS clearly lead bond spread for an entire year, until the

two converge by second half of 2010.

37

Except for a couple of quarters in 2009, Belgian CDS are chronically

higher than Belgian bond spreads.

38

For Further Study read this book

Moorad Choudhry, the author, is Head of

Treasury at Corporate Banking Division,

Royal Bank of Scotland, a Visiting

Economics Professor at London

Metropolitan University, a renowned

expert on CDS, and an avid cricket

player.