Explaining the Bond-CDS Basis –The Role of Credit Riskand Liquidity

We explore the relationship between CDS premia and bond asset swap spreads on the samereference entity. As Duffie (1999) shows, there is a clear theoretical link between CDS premiaand bond prices if the two quantities are viewed as a pure measure of credit risk. However,many studies provide evidence that factors other than credit risk seem to affect bond pricesand CDS premia, and these factors may partially obscure the relationship. We focus on thedifference between the yield spread and the CDS premium, the bond-CDS basis, and showthat the basis is highly sensitive to firm-specific and market wide credit risk and liquidity. IfCDS and bonds are used in a dynamic hedging strategy or in a basis trading strategy thatdepends on the convergence of CDS and bond markets, it is necessary to correctly quantifythe associated risks of these strategies.