Arbitrage Costs and the Persistent Non-Zero CDS-Bond Basis: Evidence from Intraday Euro Area Sovereign Debt Markets
33 Pages Posted: 9 Nov 2016
Date Written: October 7, 2016
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: Suggested Citation