Advanced Finance

The CDS-cash Basis and What It Prices

The same credit risk trades at two different prices in two markets, persistently and by hundreds of basis points in a crisis. Learn what that gap is actually paying for — funding, documentation, and a delivery option — and why calling it an arbitrage has cost people a great deal of money.

  • Expert
  • 15 min total
  • 14 chapters

What decision this helps you make: Whether a gap between a bond spread and a credit default swap spread on the same issuer represents a trade worth putting on, and what the position really earns once repo, haircuts, margin, and documentation risk are priced.

What this topic is

The credit default swap to cash basis is the difference between the spread on protection against an issuer and the spread on that issuer's own bond. Basis equals the credit default swap spread minus the cash bond spread. When the basis is negative, protection is cheaper than the bond's credit spread, so an investor can buy the bond, buy protection, and appear to hold hedged credit risk at positive carry. That combination is the negative basis trade, and for two decades it has been one of the most heavily used relative value positions in credit — and one of the most instructive, because it is not an arbitrage and everything that stops it from being one is a real cost or a real risk.

Why it matters

This is where limits to arbitrage stop being a theoretical phrase and become a repo desk. A negative basis position earns the basis only if you can finance the bond, and financing is what disappears exactly when the basis is widest. The trade requires balance sheet, collateral, and the ability to meet margin calls on the protection leg that are not matched by cash inflows on the bond leg. Understanding the basis therefore teaches three things at once: how the same risk gets priced differently in a funded and an unfunded market, what a credit default swap contract actually promises that a bond does not, and why apparent free money in credit markets is almost always compensation for something you had not yet counted.

Who should learn it

Credit relative value and capital structure traders, fixed income portfolio managers who use synthetics alongside cash, risk and treasury functions pricing funding into trading decisions, and anyone who has been shown a basis chart and told the market is mispriced.

What you will understand

  • How to compute the basis correctly, and which cash spread measure to use
  • What a negative basis trade actually earns once repo, haircuts and unsecured funding are charged against it
  • The structural drivers that push the basis positive and negative, and why they change sign in a crisis
  • How the credit default swap confirmation differs from a bond indenture in ways that break the hedge

Prerequisites

Common misconception

"A negative basis is free money — you buy the bond, buy the protection, and pocket the difference with no credit risk." Three things are wrong with this. First, the bond has to be financed, and the repo spread plus the cost of funding the haircut typically consumes most of the basis; a 45 basis point basis in the worked example below nets to about 3 basis points of carry. Second, the two legs have completely different cash flow mechanics — the protection leg is margined daily and the bond is not, so a widening spread produces margin calls against an unrealised gain you cannot monetise. Third, the hedge is only as good as the documentation: the contract references a legal entity, a seniority, and a defined set of credit events, and your bond may not sit where you think it does.