Re-issue of the first XAIA-Institute article!
Investing into a bond and at the same time buying CDS protection on the same bond is known as buying a basis package. Loosely speaking, if the bond pays more than the CDS protection costs, the position has an allegedly risk-free positive payoff known as "negative basis". However, several different mathematical definitions of the negative basis are present in the markets, all of them appearing reasonable on the first glimpse. The present article dares a second glimpse and introduces well-known and innovative measurements of negative basis, explores their properties, and discusses their pros and cons.
The cash flows of a callable bond depend on the issuer’s decisions in the future, hence are unknown today. Consequently, hedging the default risk of such a bond with a maturity-matched credit default swap (CDS) bears the risk that the CDS becomes orphaned after an early call and needs to be closed with a significant loss. A practical solution might be to split the CDS hedge into several maturity buckets, covering the range of potential call dates. We describe in simple terms how the allocation of the CDS hedge into different maturity buckets can be achieved, based on the computation of market-implied probabilities that the issuer exercises his or her call rights.
We collect some technical difficulties and pitfalls when measuring the negative basis of a position that hedges a bond with a CDS insurance contract. These are: the problem with short maturities, the difficulty to choose an appropriate hedge ratio in the Z-spread method, and the effect of the standardized quarterly frequency of the CDS payment dates.
For standard CDS the recovery rate and thus the protection payment in case of a default event depends on the reference obligation’s price calculated in the auction process after a default event, which implies an uncertainty in the protection payment. In some cases, e.g. when a credit event seems to be quite probable, an investor aims to eliminate this uncertainty. Recovery Swaps provide a way to do so. This article gives a short introduction to recovery products and their mechanisms and highlights the calculation of the invested capital for Recovery Swaps in practice.
The derivations of the market standard formulas for the pricing of single-name CDS options are reviewed. Adaptations to the current market practice of trading CDS at standardized running coupons with an initial upfront payment are discussed.