Using a sample of Credit Default Swap (CDS) prices and corresponding reference corporate bond yield spreads for the period 6/2008 to 9/2009, we show that funding liquidity (shadow cost of capital for arbitrageurs) as well as asset specific liquidity (determinants of margin requirements) explain recent deviations in the arbitrage based parity relationship between the CDS prices and bond yield spreads (CDS-Bond spread basis). Collectively our analysis corroborates the theory on the determinants of the basis, and suggests that it is important to distinguish between these two types of liquidity in determining the circumstances in which relative prices will converge. Median annualized returns for a sample convergence type trading strategy with typical levels of leverage are 80% with a median holding period of 127 days, but the path to convergence is not smooth.
Arbitrage is one of central tenets of financial economics that enforces the law of one price and keeps markets efficient. Arbitrage based pricing is based on the idea that if two assets have the same payoffs in all future states of the world, they ought to have the same price in a perfect financial market. In theory, if the prices of these two assets diverge, market participants will short sell the more expensive asset and purchase the less expensive one, and as a result make a sure profit without making any investment, and without taking any risk. Duffie (1999) shows that an arbitrage based argument links the relative values of credit default swaps (CDSs) and bonds yield spreads of the associated firm (discussed in more detail in section II).
The basis or the difference between the CDS price and the corresponding bond yield spread should theoretically be close to zero. While prior research has documented deviations from parity (e.g., Longstaff, Mithal and Neis (2005) report a 60 basis point average spread), the extent of the recent deviations have drawn scrutiny from the press and investors alike. For example, Figure 1 is a graphical depiction of the basis of a bond of Computer Science Corporation. The extent of the absolute deviation from parity (the basis) exceeds 600 basis points on a few dates, and has remained at an elevated level since the onset of the financial crisis.
