Category:FRM2009 -> Full1
Question:
[source 2009 sample Full Exam 1] E1.42. As an approximation, which is true:

a. Default swap spread = Return of a risky bond + Return of a risk-free bond
b. Default swap spread = Return of a risky bond - Return of a risk-free bond
c. Default swap spread = Return of a risky bond x Return of a risk-free bond
d. Default swap spread = Return of a risky bond x (1 - Return of a risk-free bond)

[my adds]

42b. What does J. Hull say is the best proxy for the risk-free rate?

42c. If the default swap spread is too cheap (or risky bond return is too rich), describe the “negative basis trade” an arbitrager can use.

42d. As an alternative to buying a risky bond, an investor can sell credit protection by selling a credit default swap (i.e., to be short the CDS is to be synthetically long the bond). Although superficially similar (i.e., both receive spread/premiums as compensation for credit risk), what are the difference(s) in risk to the both counterparties in the CDS trade?

42e. [source: Neftci] As an alternative to investing in a risky bond, the investor can replicate the position synthetically with a CDS. If the bond coupons are fixed but the riskless investment (money market deposits) are floating/variable, what is the synthetic equivalent to taking a long position in the risky bond?

42f. [L2 only] What is the CDS basis?

42g. In practice, the CDS basis is non-zero, why?

Answers:

42. CORRECT: B

The buyer of a risky bond can hedge the credit risk of the risky bond using a default swap. Entering into the swap trade reduces credit risk. To preclude arbitrage, the buyer of the risk bond has to receive the same return as the risk?free asset, or:

Return of a risky bond = Return of a risk?free bond + Default swap spread

Reference: Hull, Chapter 23.

42b. What does J. Hull say is the best proxy for the risk-free rate?
Traders usually use LIBOR/swap rates as proxies for risk free rates when valuing derivatives.

42c. If the default swap spread is too cheap (or risky bond return is too rich), describe the “negative basis trade” an arbitrager can use.
Buy the coupon-bearing bond (long bond) and buy credit protection (long CDS) because the CDS is giving protection against default, but the cost of protection is less than the coupon.
See Zero Hedge for expert help:
http://zerohedge.blogspot.com/2009/01/bloomberg-pitching-negative-basis-trade.html
http://zerohedge.blogspot.com/2009/01/was-merrill-casualty-3-of-basis-trade.html

42d. As an alternative to buying a risky bond, an investor can sell credit protection by selling a credit default swap (i.e., to be short the CDS is to be synthetically long the bond). Although superficially similar (i.e., both receive spread/premiums as compensation for credit risk), what are the difference(s) in risk exposure to both sides of the CDS trade?

The bond investor is exposed to market risk (interest rate changes), the CDS investor is generally not.
The bond investor must all fund the bond.
(finally, the bond investor may have currency exposure)

To the investor (writing credit protection), the CDS is (fundamentally) pure credit default risk exposure; i.e., a more limited exposure than the exposure implied by funding a bond.
To the credit protection buyer, the key difference is the bond was funded but the CDS is not (though it may be collateralized): the CDS buyers chief risk has become counterparty risk.

42e. [source: Neftci] As an alternative to investing in a risky bond, the investor can replicate the position synthetically with a CDS. If the bond coupons are fixed but the riskless investment (money market deposits) are floating/variable, what is the synthetic equivalent to taking a long position in the risky bond?

Long risk bond = short CDS + deposit into floating money market + fixed receiver in an interest rate swap
i.e., the floating money market returns are swapped for fixed swap coupons.

42f. [L2 only] What is the CDS basis?
CDS basis = credit default spread - asset-swap spread

42g. In practice, the CDS basis is non-zero, why?

As usual, both fundamental factors (i.e., can be ex ante specified and therefore ought to be reflected in compensation differences) and technical factors (non contractual and difficult to ex ante specify; not classically easy to model. As in liquidity and supply/demand).

From Moorad Choudhry’s Credit Default Swap Basis
(my Amazon review here @ http://www.amazon.com/review/R2V8C4LRA2GC4R/ref=cm_cr_rdp_perm)

Fundamental Factors
* Funding versus Libor: “A cash bond investor will need to fund the position, and we take the bond’s repo rate as its funding rate. The funding rate, or the bond’s cost-of-carry, will determine if it is worthwhile for the investor to buy and hold the bond. A CDS contract, however, is an unfunded credit derivative ...)
* Counterparty risk: “the protection buyer in a CDS contract takes on the counterparty risk of the protection seller, which does not occur in the cash market. This exposure lasts for the life of the contract…”
* CDS premiums are above zero;
* Greater protection level of the CDS contract;
* Bond identity and the delivery option
* Legal risk associated with CDS contract documentation;

Technical (market) factors
* Market demand
* Liquidity premium: “the CDS for a particular reference asset may reflect a liquidity premium for that name. An investor seeking to gain exposure to that name can buy the bond in the cash market or sell protection on it in the CDS market. For illiquid maturities or terms, the protection seller may charge a premium.”
* Shortage of cash assets
* Structured finance markets
* New market issuance: “the impact of new bond and loan issues on the CDS basis illustrates the rapid acceptance of this instrument in the market, and its high level of liquidity.”

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