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FRM Part II · FRM Exam Part II · Credit Derivatives

Bond yields for a risky 5-year bond are 6.0% and the risk-free 5-year rate is 4.5%, both on a comparable basis. A CDS on the same issuer trades at 190 bp. Ignoring other frictions, what is the CDS-bond basis, and what does it suggest?

The basis is positive 40 basis points, meaning the CDS is expensive relative to the bond. The bond spread over the risk-free rate is 150 basis points, and the CDS trades at 190, so CDS minus bond spread is plus 40.

  1. APositive basis of 40 bp; the CDS is expensive relative to the bondCorrect
  2. BNegative basis of 40 bp; the CDS is cheap relative to the bond
  3. CNegative basis of 150 bp; the bond is expensive
  4. DPositive basis of 190 bp; the bond is cheap

Explanation

Bond spread = 6.0% − 4.5% = 150 bp. Basis = CDS spread − bond spread = 190 − 150 = +40 bp. A positive basis means protection is expensive relative to the cash bond. Negative basis would require the CDS to be below the bond spread.

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