The Persistent Negative CDS-Bond Basis During The 2007/08 Financial Crisis
This papers studies price discrepancies between CDS and bonds spreads, i.e. the basis, for a sample of investment-graded US firms. In normal market conditions the basis is approximately zero. During the crisis 2007/08, due to funding liquidity shortage and increased risk in the financial sector, which exposes protection buyers to counter-party risk, the "Basis trade" is costly and risky. Results show that the basis is generally negative, time varying and strongly related economic variables that are proxies for funding liquidity conditions (cost of capital and hair cuts), risk in the interbank lending market, "Flight to liquidity" and the risk premium in the equity market, such as the TED spread, the S&P 500 realized volatility, the OIS-T-Bill spread and the S&P 500 risk premium.