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FRM Part I · FRM Exam Part I · Credit Risk Transfer Mechanisms

A bond yields 6.0% and a risk-free rate for the same maturity is 3.5%. The 5-year CDS spread on the issuer is 2.0%. Using the CDS-bond basis defined as CDS spread minus bond spread (bond spread over risk-free), what is the basis and which interpretation is the most consistent?

The basis is -0.5%, because the bond spread is 2.5% and the CDS spread is 2.0%. A negative basis means the bond earns more than protection costs, so buying the bond and buying CDS protection can capture roughly 0.5% net, subject to funding and other risks.

  1. ABasis of -0.5%; a negative basis trade (buy bond, buy protection) may offer an arbitrage-like gainCorrect
  2. BBasis of +0.5%; a negative basis trade is attractive
  3. CBasis of -4.0%; the bond is overpriced relative to CDS
  4. DBasis of +2.5%; protection is cheap relative to the bond

Explanation

Bond spread = 6.0% - 3.5% = 2.5%. Basis = 2.0% - 2.5% = -0.5%. A negative basis means the bond pays more spread than the cost of protection, so buying the bond and protection locks in about 0.5% net, subject to funding and other risks. A positive basis would require CDS above the bond spread.

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