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The credit default swap (CDS) market has increasingly become a key source of relative value among traditional money managers in recent years. In this report, we focus on one form of CDS relative value: basis packages. A basis package is the purchase (sale) of a specific credit exposure in the cash market and the simultaneous sale (purchase) of the same risk in the CDS market-ideally, but not necessarily, at two different prices. Specifically the basis can be defined as:
Basis = CDS spread
- cash bond spread
In practice, there are two typical basis package strategies:
1. A "negative basis" package strategy (buy bond/buy protection) typically is motivated by a relatively low spread in the CDS market for a particular credit, and a higher spread for the cash bond. Essentially, negative-basis-package investors attempt to earn a risk-free return by buying and selling the same credit exposure via alternative instruments in different markets.
Throughout this report we refer to a long cash position combined with the ownership of credit protection as a negative basis package, irrespective of spread pick-up or give-up. We do this to emphasize that pick-up can be viewed in total-return terms, not just in a spread context.
2. A "positive basis" package strategy (sell bond/sell protection) typically attempts to take advantage of a relatively high CDS spread for a particular company and a relatively tight spread for a comparable cash bond.
Throughout this report we refer to a short cash position combined with the sale of credit protection as a positive basis package, regardless of spread pick-up/give-up. Again, we do this to emphasize other sources of value that may drive the package's prospects in a total-return context.
The most common approach to gauging basis package relative value is a comparison of LIBOR spreads, although this is not always a straightforward task. All else being equal, the bigger the spread pick-up the better, but other factors can be equally as important, particularly in a trading context.
For example, if credit exposure is bought and sold simultaneously in two different forms in two different markets in order to pick up risk-free spread, risk, in all its various forms, must be fully hedged. (If not, "risk-free" spread is only compensation for unidentified risk.) We find...