Master thesis Banking & Finance

The negative basis Credit Default Swap contracts and credit risk during the financial crisis

University of Zurich Swiss Banking Institute Chair of Financial Engineering Prof. Dr. Leippold

Matthias Schnare

Due date: 13th October 2010

Executive Summary
Problem Description
The current developments in the credit or bond markets, influenced by the financial crisis and the economic downturn, revive a discussion about credit derivatives as an instrument of speculation and one cause or determinant of the financial crisis. Currently, CDS are used to speculate against the solvency of the different governments. Critics look at CDS contracts as Over-the-counter (OTC) instruments that are not regulated and as bilateral contracts which can have a big influence on the financial position of market participants and on the real credit markets. CDS contracts are mainly instruments for investors to insure against a default of the debtor. For the seller of the CDS they are a possibility to participate in risks he perhaps could not have taken on the bond markets otherwise. These contracts separate the default risk of the debtor from the market conditions, e.g. the market interest rates. They make it possible to only trade the credit risk of a company or a country. Therefore, they can be instruments to proof the bond values and indicators for the real credit risk of the underlying. The discussion about CDS contracts is mostly a discussion including many prejudices and it deals with aspects from different topics which cannot be mixed. Therefore, a clear picture of advantages and disadvantages and especially values and risks of CDS is difficult to be found in the current public discussion and economic newspaper articles. A further phenomenon is that bond markets and CDS markets have lost their connection in the financial crisis. So the credit risk on both markets is valued differently: the prices on the two markets differed so much that market participants used these arbitrage possibilities to earn credit risk-free money for themselves and their customers. The price difference, if the CDS price is lower than the credit risk priced by the bond of the same reference entity, is called negative basis. It can be traded with a simple combination of the underlying bond and the fitting CDS contract. One of the causes of the basis can be the different liquidity level in the two separated markets. For the development of the basis during the crisis it is important to ask how big the changes are compared to the situation before the financial crisis and also how
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important the credit rating or the industry of the reference entity is. A wide basis offers the opportunity to earn credit risk-free money. A negative basis strategy consists of buying a CDS contract and being long in a bond. Over a longer time period the bond price shall enhance. The investor gains credit risk-free money with the strategy due to the enhancement of the bond price. If the underlying bond defaults, the CDS contract counterparty pays the nominal to the investor. For this default protection he pays a lower CDS spread than he earns with the bond. Some banks constructed certificates for customers or used their proprietary trading to trade the basis.

Methodology
The thesis provides three different aspects. In the first part of the thesis the focus is on credit derivatives, especially CDS contracts. It is explained how the CDS spread is calculated and how the market for CDS contracts work. The current market and the discussion about risks and opportunities by these instruments are dealt with. Several prejudices and opinions are discussed. Also the situation of regulation is considered and suggestions for the future are made. In the second part an empirical analysis is examined. 24 companies with different ratings and their basis are analyzed. The basis development over five years from March 2005 until October 2010 is tracked. With the average data and some individual results for the data three hypotheses are checked. The three hypotheses are: 1.During the financial crisis, a higher positive or negative basis than before can be found, 2.The basis for lower-rated (below A-) companies is wider than for well-rated reference entities (from A-) in the financial crisis. The basis is negative for these companies and last 3.Some industries show a more negative average basis than others. A more stable business supports a lower basis during the financial crisis. An unstable business or industry leads to a more negative basis. In the last part a product and a strategy to trade the basis are suggested. The construction, the opportunities and risks by the new market developments are discussed.

Results and Assessment

The discussion about the credit derivatives and especially CDS contracts shows that CDS contracts did not cause the financial crisis, but they were instruments to handle
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the transfer of credit risk and could be bought and sold unregulatedly Over-thecounter (OTC). The interbanking market, as the main market for CDS contracts, is always strongly connected even without CDS contracts. Therefore, CDS contracts consequently do not mean a special or further risk if they are used appropriately. For all market participants this means to consider all the risky positions they take on their trading book or portfolio. Beside other functions of CDS contracts, for example hedging individual credit risk and diversifying a portfolio of credits, it is possible to speculate on credit worthiness. Speculation led to two different consequences on the markets: On the one hand speculation of market actors spends liquidity and improves innovation processes on the market. It leads to a faster processing of market information and gives other market participants the opportunity of trading CDS contracts to diversify their credit risk in a better way. On the other hand speculation can lead to a concentration of risk on a few market actors. If something goes wrong on the markets, this concentration of risk can lead to a system breakdown. The positions of the actors cannot be overseen. Even inexperienced investors can trade with CDS contracts and take risks they cannot bear appropriately. A simultaneous acting of speculators can lead to a further pressure on almost defaulting market participants. But a homogenous group of speculators is not existent in reality. As every derivative CDS contracts are a zerosum game so that the counterparts have a different expectation of the market development and just one side can be right. In normal market circumstances, just the information of the markets and the expectations about the future are priced by CDS contracts. Before the financial crisis the basis, as the difference of the CDS spread and credit risk spread of a bond, was positive and not far from zero on the markets for a long time. This is dependent on the rating of the underlying company. The results of the empirical study support this theory. For the empirical study the special situation of the financial crisis for the worldwide financial markets is taken into account by the three hypotheses. The basis is expected to widen and to turn negative for lower-rated companies. The B-rated companies have a wide negative basis especially during the melting point of the crisis
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. For the A-rated companies, a smaller negative basis or stronger positive basis can be found. On an average a negative basis for B-rated companies and a positive basis for A-rated companies can be seen during the crisis. The overall basis develops as proposed: The basis is widening with a higher standard deviation. As a whole it is also negative during the crisis, because in this situation the lower-rated companies develop a more extreme negative basis. The different liquidity levels in the cash bond market and CDS market are the causes for this strong basis development. A-rated bonds could be used by the banks as collateral trading with the central banks. Therefore, B-rated bonds were sold and Arated bonds were bought. So the prices on the bond markets developed in a converse way. The CDS market was not really influenced by these developments on the bond markets. Between the different industries differences of the basis development can be seen. The automotive industry with a lower default probability as a whole has a more positive basis most of the time. The media/telecommunication sector as a more unstable industry has a wide average negative basis and develops negatively for a longer time during the financial crisis. The found basis development and especially the negative basis were used by banks to trade or to sell products to their customers. In the market circumstances of the crisis a credit risk-free product with an enhanced return was very attractive. The widening of the basis during the lifetime of the bond is the risk of these strategies and products. So the investor can get pressure on his balance sheet. The counterparty of the CDS contract can default as well and so this strategy is not credit risk-free anymore. Banks have taken these risks on their balance sheet in the financial crisis. However, the CDS-bond-basis is an interesting field for further developments of products and empirical studies concerning the market circumstances and their influence on the basis.