The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns

Journal of Futures Markets, Vol. 37, 836-861, August 2017

WBS Finance Group Research Paper No. 157

42 Pages Posted: 22 Mar 2011 Last revised: 26 Dec 2019

See all articles by Gi H. Kim

Gi H. Kim

Warwick Business School - University of Warwick

Haitao Li

University of Michigan - Stephen M. Ross School of Business; Cheung Kong Graduate School of Business; Cheung Kong Graduate School of Business

Weina Zhang

Department of Finance, National University of Singapore; National University of Singapore Risk Management Institute

Date Written: December 15, 2016

Abstract

We provide a comprehensive empirical analysis on the implication of CDS-Bond basis arbitrage for the pricing of corporate bonds. Basis arbitrageurs introduce new risks such as funding liquidity and counterparty risk into the corporate bond market, which was dominated by passive investors before the existence of CDS. We show that a basis factor, constructed as the return differential between LOW and HIGH quintile basis portfolios, is a superior empirical proxy that captures the new risks. In the cross section of investment grade bond returns, the basis factor carries an annual risk premium of about 3% in normal periods.

Keywords: Credit Default Swap, CDS-Bond Basis Arbitrage, Corporate Bond Returns, Basis Risk Factor, Financial Crisis, Funding Liquidity, Counterparty Risk, Limits-to-Arbitrage

JEL Classification: G10, G12

Suggested Citation

Kim, Gi Hyun and Li, Haitao and Zhang, Weina, The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns (December 15, 2016). Journal of Futures Markets, Vol. 37, 836-861, August 2017; WBS Finance Group Research Paper No. 157. Available at SSRN: https://ssrn.com/abstract=1787628 or http://dx.doi.org/10.2139/ssrn.1787628

Gi Hyun Kim

Warwick Business School - University of Warwick ( email )

Coventry CV4 7AL
United Kingdom
+44 (0)24 7652 3849 (Phone)

Haitao Li (Contact Author)

University of Michigan - Stephen M. Ross School of Business ( email )

701 Tappan Street
Ann Arbor, MI MI 48109
United States
734-615-5475 (Phone)

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Cheung Kong Graduate School of Business ( email )

Oriental Plaza, Tower E3
One East Chang An Avenue
Beijing, 100738
China

Weina Zhang

Department of Finance, National University of Singapore ( email )

Mochtar Riady Building
15 Kent Ridge Drive
Singapore, 119245
Singapore
65168120 (Phone)
67792083 (Fax)

HOME PAGE: http://bizfaculty.nus.edu/faculty-profiles/108-weina

National University of Singapore Risk Management Institute ( email )

21 Heng Mui Keng Terrace
Level 4
Singapore, 119613
Singapore

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