Arbitrage costs and the persistent non-zero CDS-bond basis: Evidence from intraday euro area sovereign debt markets

Jacob Gyntelberg, Peter Hördahl, Kristyna Ters and Jörg Urban

No 631, BIS Working Papers from Bank for International Settlements

Abstract: We find evidence that in the market for euro area sovereign credit risk, arbitrageurs engage in basis trades between credit default swap (CDS) and bond markets only when the CDS-bond basis exceeds a certain threshold. This threshold effect is likely to reflect costs that arbitrageurs face when implementing trading strategies, including transaction costs and costs associated with committing balance sheet space for such trades. Using a threshold vector error correction model, we endogenously estimate these unknown trading costs for basis trades in the market for euro area sovereign debt. During the euro sovereign credit crisis, we find very high transaction costs of around 190 basis points, compared to around 80 basis points before the crisis. Our results show, that even when markets in times of stress are liquid, the basis can widen as high market volatility makes arbitrage trades riskier, leading arbitrageurs to demand a higher compensation for increased risk. Our findings help explain the persistent non-zero CDS-bond basis in euro area sovereign debt markets and its increase during the last sovereign crisis.

Keywords: sovereign credit risk; credit default swaps; price discovery; regime switch; intraday; arbitrage; transaction costs (search for similar items in EconPapers)
Pages: 45 pages
Date: 2017-04
New Economics Papers: this item is included in nep-mst
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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