Analysis of CDS Spread Fluctuations with an Application to the Negative Basis Arbitrage

Abstract

In this article, we first construct the empirical measure of spread (EMS) to capture the dynamics of quoted CDS spreads. It is the measure of creditworthiness of a company derived from the asset model in Egami and Kevkhishvili [2017]. We then use the information provided by the EMS to derive a refined negative CDS-bond basis trading strategy. Our contributions are twofold. By analyzing the period encompassing the global financial crisis, we find that the EMS is a forward-looking or leading indicator and can explain the movement of near future CDS spreads (20 or 30 days ahead). We then demonstrate that this feature of the EMS is present in non-crisis periods as well: therefore, the EMS could be used to predict future movement of CDS spreads. \n \nThe second contribution is to improve efficiency in negative basis arbitrage trading. Specifically, we set up a finite-horizon optimal stopping problem for an investor who uses CDS contracts to hedge a long position in a zero-coupon bond. Using this problem, we provide a trading tool for the investor and show that the information obtained from the EMS can enhance the gain from negative CDS-bond basis arbitrage.