Financial markets experienced tremendous disruptions during the 2007-2009 financial crisis. Credit spreads across all asset classes and rating categories widened to unprecedented levels. Perhaps even more surprising, many relations that were considered to be text-book arbitrage before the crisis were severely violated. For example, in currency markets, violations of covered interest rate parity occurred for currency pairs involving the US dollar (Coffey, Hrung, Sarkar (2009)). In interest rate markets the swap spread, which measures the difference between Treasury bond yields and libor swap rates, turned negative. In Interbank markets, basis swaps that exchange different tenor LIBOR rates (e.g., 3-month for 6-month) deviated from zero. In inflation markets, break-even inflation rates turned negative. In credit markets, the CDS-bond basis which measures the difference between CDS and cash-bond implied credit spreads turned negative.
These anomalies suggest that such relations are not, in fact, arbitrage opportunities in the traditional textbook sense. It seems important to understand why these disruptions occurred. One possible explanation is that arbitrage relations broke down during the crisis because of institutional or contractual features. For example, many of these relations (but not all), involve a fully funded (e.g., cash) instrument and one or more unfunded derivative positions. This raises the possibility that counterparty risk on the derivative made the arbitrage risky. It also raises the possibility that funding costs on the cash instrument are responsible for the deviations. In the former case, the payoff of the arbitrage trade is not risk-free for any investor, whereas in the latter case, the payoff to the arbitrage trade would be risk-free for an investor with infinitely deep pockets.
More generally, these violations could be evidence of classical ‘limits to arbitrage,’ such as the inability of arbitrageurs to raise capital quickly and/or their unwillingness to take large positions in these ‘arbitrage’ trades because of marking to market risk, or, more generally, market segmentation. Consequently, the dynamics of the arbitrage violations should be affected by the structure of funding markets, the ability of investors to process information, and the ability to move capital across markets (Duffie (2010)) among others. Certainly, the financial crisis provides a nice laboratory to test some of those theories (Gromb and Vayanos (2009)).
In this paper, we focus on the CDS-bond basis, which measures the difference between credit default swap (CDS) spread of a specific company and the credit spread paid on a bond of the same company. Figure 1 plot the time series of the average CDS-bond basis for investment-grade and high yield bonds, where the funding cost is measured by the libor swap curve. The figures show that the basis, which hovers usually around +5 bps, fell to -250 bps for investment-grade firms and -650 bps for high yield firms. At first sight, a large negative basis smacks of arbitrage, since it suggests that an investor can purchase the bond, fund it at libor swap, and insure the default risk on the bond by buying protection via the CDS contract. The resulting trade is ‘virtually’ risk-free and yet, as the figures show it generates between 250 and 650 bps in guaranteed return per annum.
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The Determinants of the CDS-Bond Basis During the Financial Crisis of 2007-2009
