Dr. Jan-Frederik Mai,Mohammadali Montazeri
The negative basis is an annualized earnings figure. It is supposed to measure the annualized excess return of a bond investment after having hedged away issuer-specific default risk completely via credit default swap (CDS) protection. For callable bonds a mathematically rigorous definition of the negative basis is particularly challenging because the future cash flows of the bond depend on the issuer’s call decision and are random. We propose a definition based on a specific default intensity model. It is demonstrated by means of an example that the resulting negative basis measurement is smaller than it would be under the assumption of knowledge about the call time point. This is a desirable property because eliminating the credit risk associated with a bond issuer via a CDS hedge is more expensive in the presence of call rights for the issuer.
Static pricing-hedging duality for credit default swaps and the negative basis arbitrage
Portfolio selection based on graphs: does Mr. Markowitz have his finger in the pie?