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FRM Part II · FRM Exam Part II · Estimating Default Probabilities

A credit analyst notes that a corporate bond's yield exceeds the risk-free rate by 300 basis points, while the same issuer's CDS spread is 220 basis points, so the CDS-bond basis is negative. Which interpretation is most appropriate?

A negative basis means the CDS spread is below the bond's spread over the risk-free rate. This can reflect liquidity or other non-default elements in the bond spread, or an arbitrage opportunity of buying the bond and protection together to lock in the difference.

  1. AThe CDS market must be overstating the issuer's default probability relative to the bond market
  2. BThe bond is guaranteed to default before the CDS contract matures
  3. CThe CDS spread cannot be used to estimate default probabilities when a basis exists
  4. DThe bond spread may include liquidity and other non-default components, or an arbitrage of buying the bond and buying CDS protection may existCorrect

Explanation

A negative basis means the CDS spread is below the bond spread. Part of the bond spread can reflect illiquidity or funding costs. A trader can also buy the bond and buy protection to earn the positive net spread, which is the classic negative-basis trade. The market is not overstating default risk in the CDS market, since the CDS spread is lower than the bond spread.

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