Why basis swap is negative

In the credit derivatives market, basis can be positive or negative. A negative basis means that the CDS spread is smaller than the bond spread. When a fixed-income trader or portfolio manager refers to spread, this represents the difference between the bid and ask price over the treasury yield curve treasuries are generally considered a riskless asset. For the bond portion of the CDS basis equation, this refers to a bond's nominal spread over similar-term treasuries, or possibly the Z-spread.

Because interest rates and bond prices are inversely related, a larger spread means the security is cheaper. Fixed-income participants refer to the CDS portion of a negative basis trade as synthetic because a CDS is a derivative and the bond portion as cash. So you might hear a fixed-income trader mention the difference in spread between synthetic and cash bonds when they are talking about negative basis opportunities. To capitalize on the difference in spreads between the cash market and the derivative market, the investor should buy the "cheap" asset and sell the "expensive" asset, consistent with the adage "buy low, sell high.

You can think of this as an equation:. It is assumed that at or near bond maturity, the negative basis will eventually narrow heading toward the natural value of zero. As the basis narrows, the negative basis trade will become more profitable. The investor can buy back the expensive asset at a lower price and sell the cheap asset at a higher price, locking in a profit.

The trade is usually done with bonds that are trading at par or at a discount, and a single-name CDS as opposed to an index CDS of a tenor equal to the maturity of the bond the tenor of a CDS is akin to maturity.

The cash bond is purchased, while simultaneously the synthetic single-name CDS is shorted. When you short a credit default swap, this means you have bought protection much like an insurance premium. While this might seem counterintuitive, remember that buying protection means you have the right to sell the bond at par value to the seller of the protection in the event of default or another negative credit event.

So, buying protection is equal to a short. While the basic structure of the negative basis trade is fairly simple, complications arise when trying to identify the most viable trade opportunity and when monitoring that trade for the best opportunity to take profits.

There are technical market-driven and fundamental conditions that create negative basis opportunities. Negative basis trades are usually done based on technical reasons as it is assumed that the relationship is temporary and will eventually revert to a basis of zero. Many people use the synthetic products as part of their hedging strategies, which can cause valuation disparities versus the underlying cash market, especially during times of market stress.

At these times, traders prefer the synthetic market because it is more liquid than the cash market. Holders of cash bonds may be unwilling or unable to sell the bonds they hold as part of their longer-term investment strategies. Therefore, they might look to the CDS market to buy protection on a specific company or issuer rather than simply sell their bonds. Magnify this effect during a crunch in the credit markets , and you can see why these opportunities exist during market dislocations.

A negative dollar basis means direct funding in USD — if accessible — is cheaper than synthetic funding via swaps. An apparent structural cause of the dollar basis has been regulatory tightening, which has increased balance sheet costs of arbitrage. Moreover, research has found several short-term factors. Thus, a negative dollar basis has been linked to aggregate USD strength, rising market volatility, deteriorating FX market liquidity, monetary tightening in the U. In most of these cases, the dollar basis represents dollar funding conditions not captured by published interest rates and is a valid trading signal.

The below are excerpts from the paper. Emphasis and cursive text have been added. CIP is simply the most fundamental relationship linking money and foreign exchange markets in a financially open world. In the absence of financial frictions, an arbitrageur could take advantage of the deviation from parity and earn a riskless profit. Alternatively, and equivalently if there are no frictions, no one would borrow dollars if it were cheaper to borrow foreign currency, buy dollars with the proceeds, and sell the dollars n periods forward for foreign currency as in a foreign exchange swap to repay the initial foreign-currency loan.

What has been more puzzling has been the continuation of CIP deviations — at times larger, at times smaller — well after the global financial crisis. Before the global financial crisis, CIP deviations were very small and fluctuated around zero… During the global financial crisis, short-term CIP deviations reached levels of about basis points, and more negative than basis points at the five-year horizon second figure below.

While both three-month and five-year bases had been steadily reverting to near zero through , they widened again after mid The opposite is true, if the amount of the floating rate payment exceeds the amount of the fixed rate payment.

The foregoing is a standard description of how a fixed-for-floating interest swap works. It is helpful — and necessary — background to understand what happens to an interest rate swap in a zero or negative interest rate environment.

As an initial matter, it is necessary to identify the particular reference rate specified by the interest rate swap documentation and to keep in mind that it is that rate — and only that rate — that is relevant to an analysis of a particular swap.

If we assume that the relevant reference rate is literally zero, then the next step is to consider whether there is a spread. In short, the Definitions provide two different methods for dealing with a negative floating payment amount.

Absent a special election by the counterparties to the swap, the Definitions default to a method by which the fixed rate payer would owe the floating rate payer a payment to account for a negative floating payment amount. This payment would be in addition to the fixed amount owed on the swap. As we explained in our post, the counterparties to the swap can elect for another method to apply to their swap.

Pursuant to this alternate method, if the floating payment amount is negative, then the floating rate amount is deemed to be zero and the fixed rate payer would only be obligated to pay the fixed payment amount owed on the swap. But, these two methods apply equally to a negative floating payment amount that is owed in a negative rate environment, such as would be the case if the amount of the negative reference rate exceeds the spread and the spread is added to the reference rate.