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FRM Part II · FRM Exam Part II · Credit Derivatives

A CDS index trades at a spread of 80 bps, while the weighted average of the single-name CDS spreads of its constituents is 95 bps. A trader sees this negative basis and considers an arbitrage. Which action captures the apparent mispricing, ignoring costs and frictions?

Buy protection on the index and sell protection on the constituent names. The index spread of 80 bps is below the 95 bps weighted single-name average, so paying the lower spread and receiving the higher one earns about 15 bps while credit exposures roughly offset.

  1. ABuy protection on the index and sell protection on the constituent single namesCorrect
  2. BSell protection on the index and buy protection on the constituent single names
  3. CBuy protection on both the index and the single names
  4. DSell protection on both the index and the single names

Explanation

The index is cheap relative to its constituents. Buy protection on the cheap index (pay 80 bps) and sell protection on the single names (receive 95 bps), earning about 15 bps with offsetting credit exposure. The reverse trade would lock in a loss. In practice, liquidity and contract differences can explain some basis.

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