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FRM Part II · FRM Exam Part II · Credit Derivatives

A trader notes that a corporate bond's yield spread over the risk-free rate is 220 bp, while the CDS spread for the same issuer and maturity is 170 bp, so the CDS-bond basis is negative. Which factor is most likely to contribute to a negative basis?

A liquidity premium embedded in the bond yield best explains a negative basis. The bond spread then exceeds the pure credit compensation reflected in the CDS spread, so the CDS spread sits below the bond spread.

  1. AThe cheapest-to-deliver option in the CDS contract reduces the value of protection to the seller
  2. BBond yields embed a liquidity premium that the CDS spread does not reflectCorrect
  3. CCounterparty risk makes protection sellers demand a higher spread
  4. DA short squeeze in the cash bond lowers the bond yield below risk-free

Explanation

A negative basis means CDS spread is below the bond spread. Bond spreads include a liquidity premium beyond credit risk, widening the bond spread relative to CDS. The delivery option would raise CDS spreads, and counterparty risk would lower the protection buyer's willingness to pay, not raise it.

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