The CDS-Bond Basis

We investigate the cross-sectional variation in the CDS-bond basis, which measures the difference between credit default swap (CDS) spread and cash-bond implied credit spread. We test several explanations for the violation of the arbitrage relation between cash bond and CDS contract, which states that the basis should be zero in normal conditions. The evidence is consistent with `limits to arbitrage' theories in that deviations are larger for bonds with higher frictions as measured by trading liquidity, funding cost, counterparty risk, and collateral quality. Surprisingly however, we find that the basis is more negative when the bond lending fee is higher, suggesting that arbitrageurs are unwilling to engage in a negative basis trade when short interest on the bond is high