Funding Rates in a Negative CDS Basis Trade

Summary

The document presents a negative basis trade example that compares a bond’s Z-spread with the cost of repo funding and CDS protection. It gives a Z-spread of 100 basis points, a CDS spread of 40 basis points, and repo funding at 2%, described as Libor plus 20 basis points. The stated calculation subtracts the CDS cost and the funding spread over Libor from the bond spread, leaving 40 basis points.

The question is whether using Libor in that calculation is consistent with a pricing model that discounts cash flows using a risk-free rate such as SOFR. The document raises the distinction between a risk-free benchmark used in spread calculations and a repo rate used to finance the position, but does not answer it. It therefore serves as a prompt about aligning discounting, spread conventions, and actual financing assumptions; the example alone does not establish that the residual is an arbitrage profit.

Key ideas

• The example combines a bond Z-spread, CDS protection cost, and repo funding spread to estimate a negative basis trade return.
• The calculation uses the repo spread over Libor even though the model description refers to a risk-free rate.
• The document asks how to reconcile the funding benchmark with the rate used for discounting and spread measurement.
• The example does not resolve the benchmark consistency question or establish that the calculated residual is a realizable profit.

Tags

# CDS basis trade using Risk free rate


# CDS basis trade using Risk free rate












The CDS spread pricing model uses “Risk free rate” to discount the PV and the Z-spread also uses “Risk free rate” to compute the spread. But the given example uses repo rate that comparing to Libor:

For “Negative Basis Trade”

- Z spread = 100 bps

- CDS spread = 40 bps

- Repo rate = 2% or Libor plus 20 bps

Thus, long the bond to receive at 100bps and borrow from repo at 2% or Libor plus 20 bps and buy CDS protection at 40 bps.

$$100 - (40+20) = 40bps$$

Q: Why does this example use the spread over Libor instead of the spread over “Risk free rate” (SOFR, Secured Overnight Financing Rate) in order to be consistent?

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.