The Negative CDS-bond Basis and Convergence Trading during the 2007/09 Financial Crisis

by Alessandro Fontana of University of Geneva & FINRISK

September 1, 2011

Abstract: This papers studies the CDS-bond basis, i.e. a measure of price discrepancies between CDS and bonds spreads, for a sample of investment-graded US firms. Results show that during the 2007/09 financial crisis the basis was time varying and negatively correlated to: the "Libor-OIS" spread, a proxy for the increased funding cost and risk in the interbank lending market, to measures of "bond value uncertainty", which proxy for the increase in "haircuts" and to the "OIS-Tbill" spread, a proxy for the "flight-to-liquidity" and its related liquidity premium. Moreover, large losses erased the capital used to fund margin requirements and forced convergence traders to close their positions prematurely, thus amplifying large shocks.

JEL Classification: G10,G12.

Keywords: CDS, bond spread, funding liquidity, repurchase agreement, convergence trading, nancial crisis.

Previously titled: The Persistent Negative CDS-bond Basis during the 2007/08 Financial Crisis

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