The Art of Credit Derivatives: Demystifying the Black Swan

20

Bond Price Implied Spreads

There are two possible outcomes. If the result confirms the hypothesis, then you’ve made a measurement. If the result is contrary to the hypothesis, then you’ve made a discovery.

Enrico Fermi

20.1 INTRODUCTION

Using a no-arbitrage argument the CDS spread implied by the bond’s dirty price can be computed. We apply an existing technique for corporate bonds to our one event credit model for ABS. Contrary to a CDS on a corporate bond, a CDS on an ABS does not have the cheapest to deliver option.

A widely accepted definition of the basis is as follows. The basis is the difference between the CDS spread and the asset swap spread (ASW) of the bond referenced by the CDS. This basis should technically be zero by no-arbitrage arguments. In practice it can be nonzero due to several elements, which may include counterparty risk, funding costs and mismatch between ASW and CDS contracts.

Literature on the CDS spread and hence the basis implied from bond prices is available. We refer to Zhou (2008) and references therein for more details. The main assumptions are that the investor funds at LIBOR flat and that there is no counterparty risk. We assume that collateral is posted to mitigate counterparty risk so that counterparty risk does not need to be taken into account. An interesting experiment is to change the funding assumption and assume that the investor needs to fund at a certain margin above LIBOR. Note that CDS spreads are based on LIBOR, which is by definition ...