On the White Board - December 2008

Dec 15, 2008

A Glance at The Cash-Synthetic Basis

The cash-synthetic basis is the difference between the CDS spread and the corresponding credit-risky bond yield spread. It is a general indicator of relative value of CDS versus the cash bond. When CDS spreads are wider than the bond yield spreads the basis is said to be positive, otherwise negative. In the second half of 2008 we observed unprecedented Fnancial market turbulence. The credit risky debts are trading at historical lows and the basis has been more negative than ever as the CDS market offering more liquidity than the cash market and the poor funding environment impacts bond valuations.

There are multiple forms of bond yield spreads to express the basis, among which the bond z-spread and the asset swap spread are the most commonly used. Here we introduce another form - the zero rate difference between risk-free bonds and the risky bonds. The risky zero rates are estimated via implied term structures of survival probabilities from credit-risky bond prices. We show in the following by observing the basis behavior of AIG that this methodology for risky zero rates gives plausible spread dynamics and robustness. More importantly, since this approach is consistent with CDS valuation which is also survival based, it is well suited for cash-synthetic basis estimation.

From mid-September, AIG had been experiencing a liquidity crisis. On September 16, 2008, AIG's credit rating was downgraded thus it was required to post collateral with its counterparties. AIG shares dropped 95% and its CDS spread shot up to over 350 basis points. This movement is also captured in the risky bond zero rates we constructed. Immediately, the Fed announced the bailing out of AIG. CDS spreads dropped to below 200 bp. During October and November, AIG's CDS spreads were steadily rising, implying a worsened credit situation. In this period the risky bond zero rates remained steadily slightly below 200 bp. On November 10, 2008, the US Treasury announced its rescue package, which tightened the CDS spreads to 100 bp region. Risky bond zero spread fell simultaneously to the same range. The liquidity concern and bond funding concern among other factors all drove the overall basis level to more negative.