On the negative basis trade

A short note on the connection between counter party risk in the valuation of CDS and the perceived possibility of a negative basis trade in Greek Government Bonds in the current crisis.

Okay, my first post in English, mainly because this is in respond to a discussion i found on FT Alphaville. Because I prefer some neat mathematical writing, find the post in the attached PDF. The conclusion of the article is that a widening in the gap between CDS premia and Greek government spreads is an increase in the perceived counterparty risk of the CDS.

Find the PDF here: On negative basis trade

On the negative basis trade

On FT Alphaville[1] there was a discussion on the persistence of a gap between the price of CDS on Greek Government Bonds (GGB) and the spotmarket price of GGB: As noted by Barclay Capital, the GGB spreads have widened relative to CDS premiums, allowing an arbitrage trade without default risk from the issuer of the bond.[2] One possible explanation for the persistence of the gap between CDS premia and spotmarket may be the counterparty risk. Taking some basis valuation formula, one has for the probability of default of GGB:

The value of the CDS from the perspective of a buyer is – for some value of recovery rate r, assuming no counterparty risk:

If we allow for counterparty risk , this becomes:

Now, if we allow for the weak form of the efficient market hypothesis, a widening between GGB on the spotmarket and CDS-premia could have two sources: a rise in the expected recovery rate, or a rise in the counterparty risk. Since S&P has set a low expectancy value on the recovery rate (between 30-50%, far below the average recovery rate for sovereign defaults), this persistent, and widening gap is only consistent with a widening in the counterparty risk.

[1] http://ftalphaville.ft.com/blog/2010/05/06/221576/the-gr%CE%B5%CE%B5k-n%CE%B5g%CE%B1tiv%CE%B5-b%CE%B1sis-tr%CE%B1d%CE%B5/

[2] One could buy the bond and buy default protection – a CDS – and cash in the difference between the bond interest rate and the insurence premium.

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