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FRM Part II · FRM Exam Part II · Credit Derivatives

A risk manager compares a CDS spread with the asset swap or bond spread of the same reference entity and finds the CDS spread is significantly lower than the bond spread over the risk-free rate. Which explanation is most consistent with this negative basis?

A negative basis is most consistent with the bond spread containing liquidity and funding-related premia that the CDS spread does not fully capture. The CDS then looks cheaper than the bond, even though both reference the same credit risk.

  1. ABond prices include a liquidity premium and funding cost effects that the CDS spread does not fully reflectCorrect
  2. BCDS contracts always carry a higher spread because of counterparty risk to the protection buyer
  3. CThe recovery rate on the bond is necessarily zero
  4. DThe CDS cheapest-to-deliver option has no value to the protection buyer

Explanation

A negative basis (CDS spread below bond spread) is commonly explained by bond-specific liquidity premia, funding costs and supply or demand effects that do not enter the CDS price. Counterparty risk lowers, not raises, the protection buyer's willingness to pay. A zero recovery assumption is not implied. The delivery option does have value to the buyer, so the final option is false.

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