The negative basis - Credit Default Swap contracts and credit risk during the financial crisis

Table of Contents

1. Introduction

2. Trading credit risk

2.1 Basics of credit risk

2.2 Credit derivatives: Different instruments on the market

2.2.1 Asset Swaps and Total Return Swaps

2.2.2 CDO instruments

2.2.3 Credit Spread Options

2.3 Credit derivatives: CDS Contracts

2.3.1 How they work

2.3.1.1 Fundamentals

2.3.1.2 Comparison to insurance contracts

2.3.2 Pricing CDS contracts

2.3.3 Involved risks and concerns – prejudices and the truth

2.3.3.1 The current use of CDS contracts

2.3.3.2 Connection of the global financial system

2.3.3.3 Risk-understanding of the different market actors

2.3.3.4 CDS contracts as a speculation instrument

2.3.3.5 Different maturities of CDS payments and fat tails

2.3.3.6 The price of credit risk on the market indicated by CDS contracts

2.3.3.7 Influences on the balance sheet

2.3.3.8 The moral hazard of risk shifting

2.3.3.9 CDS contracts as a tool for other derivatives

2.3.4 CDS contracts and regulation

2.3.5 Summary

3. The negative CDS basis

3.1 The theory of the basis

3.1.1 Swap spread and Treasury spread

3.1.2 The Asset Swap spread

3.1.3 The Z-Spread

3.1.4 Cash CDS-Basis dynamics: Positive and negative basis trading strategies

3.1.5 Positive or negative basis causes and situations

3.1.5.1 Physical settlement CDS as the cheapest-to-deliver option

3.1.5.2 CDS premia are always positive

3.1.5.3 Definition of the technical default and profit realization

3.1.5.4 Bonds traded strongly below and above par and concerns of shorting cash bonds

3.1.5.5 Funding issues and counterparty risk

3.1.5.6 Coupon and premium paying differences and coupon specificities

3.1.5.7 Growth on structured finance markets and different liquidity on market segments

3.1.6 The basis smile and basis trends

3.2 Empirical study – hypotheses why and where the negative basis is present

3.2.1 Larger basis in the financial crisis than before

3.2.2 Wider negative basis for bonds of lower-rated companies

3.2.3 The basis develops differently between different industries

3.2.4 Analysis details, assumptions and sample choice

3.2.4.1 Sample choice and timeframe

3.2.4.2 Assumptions and simplifications

3.2.4.3 Calculations for investigating the basis

3.2.4.4 Separation of the time horizon

3.2.5 The results for the negative basis

3.2.5.1 The overall results

3.2.5.2 Rating differences

3.2.5.3 Industry differences

3.2.6 Sample results for different companies

3.2.7 The results compared with the hypotheses and possible explanations

4. Trading strategies using the negative basis during the financial crisis

4.1 A certificate for clients of a bank

4.1.1 Determinants of the certificate

4.1.2 Idea of the certificate

4.1.3 Construction of the certificate

4.1.4 Opportunities for investor and bank due to the certificate

4.1.5 Involved risks for investor and bank

4.2 Trading strategies in the banks

4.2.1 The buy-and-hold-strategy

4.2.2 Risks and influences of the strategy

5. Conclusion

Objectives & Key Themes

The thesis aims to analyze the "negative basis" phenomenon, exploring the disconnect between bond and Credit Default Swap (CDS) markets during the financial crisis and investigating how this spread divergence can be utilized for trading strategies.

• The role and functioning of Credit Default Swap (CDS) contracts.
• Empirical analysis of the negative basis across different rating categories and industries.
• Evaluation of the impact of the financial crisis on market liquidity and basis development.
• Examination of trading strategies, including the use of certificates and buy-and-hold approaches by banks.
• Assessment of risks associated with CDS contracts and basis trading in volatile market conditions.

Excerpt from the Book

Summary of Chapters

1. Introduction: Outlines the research focus on CDS contracts, the financial crisis, and the emergence of the "negative basis" phenomenon in credit markets.

2. Trading credit risk: Provides a theoretical foundation for credit risk, credit derivatives, and the specific mechanics and risks associated with CDS contracts.

3. The negative CDS basis: Explains the theoretical underpinnings of the basis and presents an empirical study testing three hypotheses regarding basis development during the financial crisis.

4. Trading strategies using the negative basis during the financial crisis: Discusses practical applications of basis trading, including specific bank certificate constructions and proprietary buy-and-hold strategies.

5. Conclusion: Summarizes the key findings, emphasizing that CDS contracts did not cause the financial crisis but acted as tools that reflected systemic market stresses and liquidity issues.

Keywords

Credit Default Swaps, CDS, Negative Basis, Financial Crisis, Credit Risk, Asset Swap Spread, Liquidity, Arbitrage, Bond Market, Counterparty Risk, Hedging, Speculation, Investment Grade, Junk Bonds, Financial Derivatives

Frequently Asked Questions

What is the core focus of this thesis?

The thesis examines the relationship between bond prices and Credit Default Swap (CDS) spreads, focusing on the "negative basis" phenomenon—a price discrepancy that emerged between these two markets during the financial crisis.

What are the primary themes of the work?

Central themes include the functioning of credit derivatives, the empirical impact of the financial crisis on market connectivity, risk management for banking institutions, and the use of the negative basis to generate excess returns.

What is the primary research objective?

The main objective is to empirically analyze why the negative basis widened during the financial crisis, specifically investigating how rating categories and industry sectors influenced this divergence.

Which methodology does the author utilize?

The author performs an empirical analysis using historical data for 24 companies from 2005 to 2010, tracking basis development and testing three specific hypotheses regarding the impact of the crisis and credit quality on the basis.

What does the main body of the work cover?

The main body covers the theoretical definition of the basis, an empirical evaluation of basis behavior across different time horizons and industry sectors, and an analysis of practical trading strategies used by banks, such as certificates for clients.

Which keywords best characterize the research?

Key terms include Credit Default Swaps (CDS), negative basis, financial crisis, liquidity, credit risk, and asset swap spread.

How did the financial crisis affect the relationship between CDS and bond markets?

The crisis led to a liquidity dry-out in the interbank and bond markets, causing the connection between CDS and cash bond markets to break down and allowing the basis to turn significantly negative, especially for lower-rated companies.

Why are "naked" CDS contracts discussed in the thesis?

The author discusses "naked" CDS contracts as tools for speculation that can provide market liquidity but may also contribute to systemic risk and "runs" on markets when speculators coordinate their activities against specific reference entities.