hard · Debt Capital Markets pricing-yields-curve
In a negative-basis trade, an arbitrageur buys a physical corporate bond trading at a G-spread of 250 bps and simultaneously buys 5-year CDS protection on the same issuer at 180 bps.
If the investor finances the bond in the Repo market at GC - 20 bps (LIBOR being GC equivalent), what is the primary risk inherent in this 'nearly credit-hedged' position?
- The position is fully exposed to parallel upward shifts in the underlying risk-free Treasury yield curve.
- The basis trade will lose money if the issuer's credit quality improves and CDS protection cheapens markedly.
- The repo financing cost falls and carry rises if the bond goes 'on special' in the secured funding market.
- The bond may experience a 'jump-to-default' where the CDS recovery differs from the bond's market value.
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