Basis Package Relative Value

Abstract

The credit default swap (CDS) market increasingly has become a key source of relative value among traditional money managers in recent years. In this article, the authors focus on one form of CDS relative value: basis packages. A basis package is the purchase (sale) of a specific credit exposure in the cash market and the simultaneous sale (purchase) of the same risk in the CDS market—ideally, but not necessarily, at two different prices. Specifically, the basis can be defined as the CDS spread minus the cash bond spread. The authors describe key considerations regarding the construction of basis packages, and evaluate five sources of value aside from spread that can have a significant impact on returns. The key considerations in the construction of basis packages are: 1) what exactly the basis is and 2) how to hedge economic exposure properly. The five sources of value aside from spread are: 1) many variations of the same economic exposure that can be hedged via a default swap, 2) differences in credit risk across markets, 3) a funding option, 4) a sub-LIBOR skew, and 5) liquidity premiums. After discussing these factors, the authors review them in two case examples.