Analysis of CDS Spread Fluctuations with an Application to the Negative Basis Arbitrage

36 Pages Posted: 17 Jul 2019 Last revised: 1 Aug 2019

See all articles by Masahiko Egami

Masahiko Egami

Kyoto University

Rusudan Kevkhishvili

Graduate School of Economics, Kyoto University

Date Written: July 31, 2019

Abstract

In this article, we first construct the empirical measure of spread (EMS) to capture the dynamics of quoted CDS spreads. It is the measure of creditworthiness of a company derived from the asset model in Egami and Kevkhishvili [2017]. We then use the information provided by the EMS to derive a refined negative CDS-bond basis trading strategy. Our contributions are twofold. By analyzing the period encompassing the global financial crisis, we find that the EMS is a forward-looking or leading indicator and can explain the movement of near future CDS spreads (20 or 30 days ahead). We then demonstrate that this feature of the EMS is present in non-crisis periods as well: therefore, the EMS could be used to predict future movement of CDS spreads.

The second contribution is to improve efficiency in negative basis arbitrage trading. Specifically, we set up a finite-horizon optimal stopping problem for an investor who uses CDS contracts to hedge a long position in a zero-coupon bond. Using this problem, we provide a trading tool for the investor and show that the information obtained from the EMS can enhance the gain from negative CDS-bond basis arbitrage.

Keywords: CDS spreads, negative basis arbitrage, shot noise, structural model

JEL Classification: G01, G11, G12

Suggested Citation

Egami, Masahiko and Kevkhishvili, Rusudan, Analysis of CDS Spread Fluctuations with an Application to the Negative Basis Arbitrage (July 31, 2019). Available at SSRN: https://ssrn.com/abstract=3420656 or http://dx.doi.org/10.2139/ssrn.3420656

Masahiko Egami

Kyoto University ( email )

Yoshida-Honmachi
Sakyo-ku
Kyoto, 606-8501
Japan

Rusudan Kevkhishvili (Contact Author)

Graduate School of Economics, Kyoto University ( email )

Yoshida-Honmachi
Sakyo-ku
Kyoto, 606-8501
Japan

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