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The CDS-bond Basis: Negativity Persistence and Limits to Arbitrage

Author

Listed:
  • Guesmi, Sahar

    (HEC Montreal, Canada Research Chair in Risk Management)

  • Ben-Abdallah, Ramzi

    (Université du Québec à Montréal (UQAM))

  • Breton, Michèle

    (HEC Montreal, Department of Decision science)

  • Dionne, Georges

    (HEC Montreal, Canada Research Chair in Risk Management)

Abstract
We reinvestigate the CDS-bond basis negativity puzzle after the financial crisis. This puzzle is defined as the unexpected persistence of the dislocation between bond and derivative credit markets. We show that the first two moments of the basis are described by three distinct Markov regimes identified with periods related to the 2008 financial crisis. We observe that the post-crisis regime differs significantly from the crisis and the pre-crisis regimes. We then explore the cross-sectional variation of the CDS-bond basis in each regime. Using a model with several limit-to-arbitrage factors, we validate that the negative basis can be explained by liquidity risk in both the bond and CDS markets, together with counterparty risk, collateral quality, and funding constraints. Finally, we propose a model to empirically affirm that the basis negativity persistence during the post-crisis period is mainly related to a significant decrease in basis arbitrage activity, which is partly explained by the post-crisis regulatory reforms.

Suggested Citation

  • Guesmi, Sahar & Ben-Abdallah, Ramzi & Breton, Michèle & Dionne, Georges, 2019. "The CDS-bond Basis: Negativity Persistence and Limits to Arbitrage," Working Papers 19-4, HEC Montreal, Canada Research Chair in Risk Management.
    • Handle: RePEc:ris:crcrmw:2019_004
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    References listed on IDEAS

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    More about this item

    Keywords

    CDS-bond basis; Markov regime; arbitrage; liquidity; financial crisis; Basel regulation; Dodd-Frank Act.;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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