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Evaluating a CDS - basis

B

Benjamin

Member
Hi,

Reference: Ch12, CMP p.21-22

The basis is defined as the price of the CDS less the yield differential. Regarding reason 2 on page 22 as to why those may not be equal, if the CDS requires funding from the buyer, doesn't that mean the basis is positive (i.e. the price is higher than the yield differential), which per the answer to CMP q12.18 (ii) and (iii) would be the disadvantageous position to the buyer of the CDS?
 
Benjamin said:
Hi,

Reference: Ch12, CMP p.21-22

The basis is defined as the price of the CDS less the yield differential. Regarding reason 2 on page 22 as to why those may not be equal, if the CDS requires funding from the buyer, doesn't that mean the basis is positive (i.e. the price is higher than the yield differential), which per the answer to CMP q12.18 (ii) and (iii) would be the disadvantageous position to the buyer of the CDS?
Click to expand...
Hi. As the CDS requires funding it is less attractive and thus buyers are not prepared to pay such a high price (the funding is not part of the basis equation).
 
Hmmm I thought by funding it meant that the premium exceeds that yield differential and so extra money needs to be added to finance the CDS. If that's not the case, can you please explain what is meant by:

"The package of a bond plus CDS is illiquid and requires funding, and so typically basis will be negative when funding is expensive."
 
To buy a bond and pay the CDS premiums costs money (even allowing for the coupons on the bond). This cost must be funded (ie there is a cost of borrowing or opportunity cost of the money). So, if borrowing costs are high, this makes the package relatively unattractive, thus pushing down the price. If you hold the CDS only, then the premium requires funding (as there are no bond coupons to subsidise them).
 
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