CFA Level II Exam · Credit Default Swaps

Applications of CDS and Basis Trades for CFA Level 2

Updated 7 October 2026 · Fact-checked

CDS applications are uses of credit default swaps to hedge credit exposure, speculate on spread moves, trade the CDS curve, or trade the basis. Basis = CDS spread − bond credit spread. Identify the view, pick buy or sell protection, and check which leg earns the mispricing.

Understand Applications of CDS and Basis Trades

A credit default swap (CDS) lets one party transfer credit risk to another. The protection buyer pays a periodic spread. The protection seller pays if a credit event occurs. So a CDS lets you take or remove credit risk without trading the bond itself.

The first use is managing credit exposure. If you hold a bond and fear credit deterioration, you buy protection. If you want more credit exposure, you sell protection. Selling protection behaves like owning the bond: you earn the spread and lose if spreads widen. Buying protection behaves like shorting the bond: you gain if spreads widen.

The second use is speculation on spread changes. A buyer of protection expects spreads to widen. A seller expects them to tighten or stay flat. You need no bond position. CDS is often more liquid than the bond and easier to short. Value moves with the change in spread times the duration of the CDS (the risky annuity), so longer-tenor CDS move more in value per spread change.

The third use is a curve trade, which uses CDS of different maturities on the same name. You expect the CDS curve to steepen (long-tenor spreads rise relative to short-tenor) or flatten (the gap narrows). To bet on steepening, you sell protection on the short tenor and buy protection on the long tenor. To bet on flattening, you buy short-tenor protection and sell long-tenor protection. Size the legs so the trade is duration-neutral (equal spread DV01), or the result reflects a level move and not a curve move. A common trigger: a company in distress sees short-tenor spreads jump above long-tenor spreads, which is an inverted curve.

The fourth use is the basis trade. The basis is the CDS spread minus the bond's credit spread (often the Z-spread) for the same issuer and similar maturity. A negative basis means the CDS spread is below the bond spread: the bond looks cheap relative to CDS. Buy the bond and buy CDS protection. You earn the bond spread, pay the lower CDS spread, and keep the difference with credit risk hedged. A positive basis means the CDS spread is above the bond spread: the bond looks rich relative to CDS. In principle you short the bond and sell protection, but shorting the bond is hard, so positive-basis trades are less common. Basis trades are not risk-free. Funding, counterparty risk, liquidity, the cheapest-to-deliver option, and differences in contract terms can stop the basis converging.

Key formulas to remember

CDS basis: Basis = CDS spread − bond credit spread; Use the bond's Z-spread or similar spread for matching issuer and maturity. Negative: CDS below bond spread. Positive: CDS above bond spread.
Negative basis trade: Buy bond + buy CDS protection; Net carry ≈ bond spread − CDS spread, with credit risk largely hedged. Profit if the basis converges toward zero.
Positive basis trade: Short bond + sell CDS protection; Net carry ≈ CDS spread − bond spread. Bond shorting is hard, so this is less common.
Curve steepener: Sell short-tenor protection + buy long-tenor protection; Profits if long-tenor spreads rise relative to short-tenor. Flattener is the reverse.
Approximate CDS value change: ΔValue ≈ ΔSpread × duration × notional; Protection buyer gains when spreads widen; seller loses. Use the CDS risky duration.

How to solve Applications of CDS and Basis Trades questions

Use this method on any item set question about CDS applications, curve trades or basis trades.

1Find the objective in the vignette: hedge, add exposure, speculate, curve view, or basis arbitrage.
2Write the position you want in credit terms: long credit risk (like owning the bond) or short credit risk.
3Map it to CDS: buying protection is short credit; selling protection is long credit.
4For a curve trade, identify the view (steepen or flatten) and set the long and short tenors. Check the legs are sized to be duration-neutral.
5For a basis trade, compute basis = CDS spread − bond spread. Negative means buy bond and buy protection; positive means the reverse.
6Compute the net carry or the P&L from spread changes using the exhibit numbers.
7State the main risks: counterparty, funding, liquidity, contract mismatch, and basis not converging.
8Check the sign of your answer against the direction of your trade.

Quickest way: Direction-first shortcut

When to use it: Use when the question asks which position benefits from a given view and you have little time.

Spreads widen: buy protection wins. Spreads tighten: sell protection wins.
Steepener: short end sells protection, long end buys protection. Flattener: opposite.
Negative basis: bond cheap, so buy bond plus buy protection. Positive basis: bond rich, so the reverse.
Carry for the negative basis trade is bond spread minus CDS spread.

Common mistakes in Applications of CDS and Basis Trades

Mixing up which side of the CDS the basis trade uses.
Students remember 'negative basis' but not whether the bond is cheap or rich.
Fix: Negative basis means CDS spread is below the bond spread. The bond pays more, so buy it and buy cheap protection.
Computing basis as bond spread minus CDS spread.
The carry is stated as bond minus CDS, which causes confusion.
Fix: Basis is always CDS minus bond. Carry on a negative basis trade is the reverse, the positive number.
Reversing the steepener legs.
Students think of buying the maturity that they expect to widen, but forget the other leg.
Fix: Steepener: buy long-tenor protection, sell short-tenor protection. Say it as 'long end gains when it widens more'.
Calling the basis trade risk-free.
Hedging credit risk looks like full arbitrage.
Fix: Name the residual risks: counterparty, funding cost, liquidity, the delivery option and the basis widening further.
Saying selling protection reduces credit exposure.
The word 'selling' sounds like reducing a position.
Fix: Selling protection takes on credit risk, like buying the bond. Buying protection reduces it.

Worked examples

Example 1

Vignette: An analyst sees a 5-year bond from Issuer X with a Z-spread of 190 bps. The 5-year CDS on Issuer X trades at 150 bps. Q1: What is the basis? Q2: Which trade exploits it? Q3: What is the approximate annual net carry per ₹10,00,00,000 notional, ignoring funding?

Show the solution

Q1: Basis = CDS spread − bond spread = 150 − 190 = −40 bps.
Q2: The basis is negative, so the bond is cheap relative to CDS. Buy the bond and buy CDS protection.
Q3: Net carry = bond spread − CDS spread = 190 − 150 = 40 bps.
Annual carry = 0.0040 × ₹10,00,00,000 = ₹4,00,000.

Answer: Basis is −40 bps; buy the bond and buy protection; net carry is about 40 bps, or ₹4,00,000 per year, before funding and other risks.

Example 2

Vignette: Issuer Y has a 2-year CDS at 300 bps and a 10-year CDS at 250 bps. The analyst expects the credit to recover, so the curve will normalise. The analyst sizes the trade to be duration-neutral. Q1: What is the shape of the curve? Q2: Which curve trade fits the view? Q3: If the 2-year spread falls more than the 10-year spread, what happens to the curve and to the trade?

Show the solution

Q1: The short-tenor spread (300) is above the long-tenor spread (250), so the curve is inverted.
Q2: Normalising means long-tenor spreads rise relative to short-tenor, so the curve steepens. Sell 2-year protection and buy 10-year protection, sized to be duration-neutral.
Q3: If the 2-year spread falls more than the 10-year spread, the gap (10-year minus 2-year) rises, which is a steepening move.
Duration-neutral sizing means the two legs have equal spread DV01. Then the trade P&L ≈ DV01 × (change in 10-year spread − change in 2-year spread) = DV01 × change in the 10y−2y gap.
The short 2-year protection leg gains when the 2-year spread falls. The long 10-year protection leg loses when the 10-year spread falls. Because the 2-year spread falls by more and the DV01s are equal, the 2-year gain exceeds the 10-year loss.
So the gap rises, the change in the gap is positive, and the trade gains.

Answer: The curve is inverted; use a steepener (sell 2-year protection, buy 10-year protection). If the 2-year spread falls more than the 10-year spread, the curve steepens. With equal spread DV01, P&L ≈ DV01 × change in the (10y − 2y) gap, so the trade gains because the gap rises.

Exam tips

Draw a one-line sketch of the position as long or short credit before reading the answer options.
Compute basis as CDS minus bond, then decide the trade. Many wrong options reverse the sign.
For curve trades, look for duration-neutral sizing in the vignette. A trade not neutral reflects a level view too.
When asked for risks of a basis trade, give counterparty, funding, liquidity and contract or delivery mismatch.

Applications of CDS and Basis Trades in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Applications of CDS and Basis Trades: frequently asked questions

What is a negative basis trade in CDS?

The CDS spread is below the bond's credit spread. You buy the bond and buy CDS protection, earning the difference with credit risk mostly hedged. You profit if the basis moves toward zero.

How do you hedge credit risk with a CDS?

If you hold a bond, buy protection on the same issuer. If the issuer defaults or spreads widen, the CDS gain offsets the bond loss. Mismatches in maturity, seniority or terms leave some basis risk.

What is a CDS steepener trade?

It profits when the gap between long-tenor and short-tenor CDS spreads widens. You sell short-tenor protection and buy long-tenor protection, sized to be duration-neutral. A flattener is the opposite.

Why is a positive basis trade less common?

It needs you to short the bond, which is difficult and costly in many markets. Negative basis trades only need you to buy the bond, so they are more common.