Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets

33 Pages Posted: 9 Nov 2016

See all articles by Jacob Gyntelberg

Jacob Gyntelberg

Nordea Group; University of Copenhagen - Department of Economics

Peter Hördahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific

Kristyna Ters

University of Basel

Jörg Urban

Bank for International Settlements (BIS)

Multiple version iconThere are 2 versions of this paper

Date Written: October 7, 2016

Abstract

We find evidence that in the market for euro area sovereign credit risk, arbitrageurs engage in basis trades between credit default swap (CDS) and bond markets only when the CDS-bond basis exceeds a certain threshold. This threshold effect is likely to reflect costs that arbitrageurs face when implementing trading strategies, including transaction costs and costs associated with committing balance sheet space for such trades. Using a threshold vector error correction model, we endogenously estimate these unknown trading costs for basis trades in the market for euro area sovereign debt. During the euro sovereign credit crisis, we find very high transaction costs of around 190 basis points, compared to around 80 basis points before the crisis. Moreover, we find that once the threshold has been exceeded, the basis reverts back towards its long-run equilibrium substantially faster than when the basis is below the threshold. Our findings help explain the persistent non-zero basis or spread between credit risk premia in CDS and sovereign bond markets and suggest that the significant increase in the basis during the crisis was due to sharply higher costs facing arbitrageurs in the market, as well as compensation for increased risk that the trade would go against them in the short run.

Keywords: sovereign credit risk, credit default swaps, price discovery, regime switch, intraday, arbitrage, transaction costs

JEL Classification: G12, G14, G15

Suggested Citation

Gyntelberg, Jacob and Hoerdahl, Peter and Ters, Kristyna and Urban, Jörg, Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets (October 7, 2016). Available at SSRN: https://ssrn.com/abstract=2866893 or http://dx.doi.org/10.2139/ssrn.2866893

Jacob Gyntelberg

Nordea Group ( email )

Grønjordsvej 10
Copenhagen, DK - 2300
Denmark

University of Copenhagen - Department of Economics ( email )

Øster Farimagsgade 5, Bygn 26
Copenhagen, 1353
Denmark

Peter Hoerdahl

Bank for International Settlements (BIS) - BIS Representative Office for Asia and the Pacific ( email )

78th floor, Two International Finance Centre
8 Finance Street, Central
Hong Kong

Kristyna Ters

University of Basel ( email )

No Address Available

Jörg Urban (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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