The CDS-bond Basis: Negativity Persistence and Limits to Arbitrage

Sahar Guesmi (), Ramzi Ben-Abdallah (), Michèle Breton () and Georges Dionne ()
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Sahar Guesmi: HEC Montreal, Canada Research Chair in Risk Management
Ramzi Ben-Abdallah: Université du Québec à Montréal (UQAM), https://finance.esg.uqam.ca/corps-enseignant/professeurs/professeur/ben_abdallah.ramzi/
Michèle Breton: HEC Montreal, Department of Decision science, https://www.hec.ca/en/profs/michele.breton.html

No 19-4, Working Papers from HEC Montreal, Canada Research Chair in Risk Management

Abstract: We reinvestigate the CDS-bond basis negativity puzzle after the financial crisis. This puzzle is defined as the unexpected persistence of the dislocation between bond and derivative credit markets. We show that the first two moments of the basis are described by three distinct Markov regimes identified with periods related to the 2008 financial crisis. We observe that the post-crisis regime differs significantly from the crisis and the pre-crisis regimes. We then explore the cross-sectional variation of the CDS-bond basis in each regime. Using a model with several limit-to-arbitrage factors, we validate that the negative basis can be explained by liquidity risk in both the bond and CDS markets, together with counterparty risk, collateral quality, and funding constraints. Finally, we propose a model to empirically affirm that the basis negativity persistence during the post-crisis period is mainly related to a significant decrease in basis arbitrage activity, which is partly explained by the post-crisis regulatory reforms.

Keywords: CDS-bond basis; Markov regime; arbitrage; liquidity; financial crisis; Basel regulation; Dodd-Frank Act. (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 G18 G28 (search for similar items in EconPapers)
Pages: 50 pages
Date: 2019-11-04
New Economics Papers: this item is included in nep-fmk
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Persistent link: https://EconPapers.repec.org/RePEc:ris:crcrmw:2019_004

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