Arbitrage Opportunities in CDS Term Structure: Theory and Implications for OTC Derivatives

37 Pages Posted: 21 Nov 2018 Last revised: 6 Dec 2018

See all articles by Raymond Brummelhuis

Raymond Brummelhuis

University of Reims Champagne-Ardenne

Zhongmin Luo

Birkbeck, University of London

Date Written: November 19, 2018

Abstract

Absence-of-Arbitrage (AoA) is the basic assumption underpinning derivatives pricing theory. As part of the OTC derivatives market, the CDS market not only provides a vehicle for participants to hedge and speculate on the default risks of corporate and sovereign entities, it also reveals important market-implied default-risk information concerning the counterparties with which financial institutions trade, and for which these financial institutions have to calculate various valuation adjustments (collectively referred to as XVA) as part of their pricing and risk management of OTC derivatives, to account for counterparty default risks. In this study, we derive No-arbitrage conditions for CDS term structures, first in a positive interest rate environment and then in an arbitrary one. Using an extensive CDS dataset which covers the 2007-09 financial crisis, we present a catalogue of 2,416 pairs of anomalous CDS contracts which violate the above conditions. Finally, we show in an example that such anomalies in the CDS term structure can lead to persistent arbitrage profits and to nonsensical default probabilities. The paper is a first systematic study on CDS-term-structure arbitrage providing model-free AoA conditions supported by ample empirical evidence.

Thanks for the feedback from participants at the conferences where the paper was invited for presentation: Machine Learning in Quantitative Finance in Nov. 2018, London, UK.

Keywords: Arbitrage; Asset pricing; OTC derivatives; CVA; XVA; Valuation adjustment; Counterparty credit risk

JEL Classification: C4, C45, C55, C58, C63, G01

Suggested Citation

Brummelhuis, Raymond and Luo, Zhongmin, Arbitrage Opportunities in CDS Term Structure: Theory and Implications for OTC Derivatives (November 19, 2018). Available at SSRN: https://ssrn.com/abstract=3282399 or http://dx.doi.org/10.2139/ssrn.3282399

Raymond Brummelhuis

University of Reims Champagne-Ardenne ( email )

51096 Reims Cedex
France

Zhongmin Luo (Contact Author)

Birkbeck, University of London ( email )

Malet Street
London, London WC1
United Kingdom

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