Much of the considerable growth of the credit derivatives market has been driven by the use of the default swap as a proxy for cash instruments. This is predicated upon the assumption that a default swap and a par floater or asset swap (on a par asset) closely replicate the same credit exposure. However this relationship is not exact and this is reflected in the market where we observe that significant divergence can occur between default swap and cash spreads. We call this spread divergence the default-swap basis and define it as follows:
DEFAULT-SWAP BASIS = DEFAULT-SWAP SPREAD - CASH LIBOR SPREAD
The reasons for this divergence can be broken down into two categories, which we shall call fundamental factors and market factors. Fundamental factors relate to the precise specification of a default-swap contract, which make it behave differently from a cash bond. Market factors relate to the nature of the market in which the cash and default swap contracts are traded and so includes effects such as liquidity, supply and demand, and the nature of the market's participants.
Unlike cash bonds, default swaps are unfunded transactions which lock-in an effective funding rate of LIBOR. The funding cost of the institution looking to go long or short the credit therefore plays a role in determining which is the more efficient strategy--cash bond or default swap. As most market participants fund above LIBOR, they are willing to accept narrower default swap spreads than cash spreads. This decreases the basis.
2. The Delivery Option
If a credit event occurs, the protection buyer in a default swap specified with physical settlement has the ability to deliver one or more assets out of a basket of deliverable assets in return for par. If the credit event is not a full default, as in a restructuring, different deliverables may continue to trade at differing prices. This ability to switch out of one asset into a cheaper asset to deliver into the contract can then have a significant value, which depends on the probability of such a credit event and the degree of variation in the price of deliverables. The protection buyer has to pay for this optionality through a wider spread, so increasing the basis.
3. Risk of Technical Default
We define the risk of technical default as the risk that the definitions or the legal structure used in the purchase of the default protection differ from those which would constitute default on the cash bond. The main concern is for protection sellers is they may have to pay out on an event which is not a full default. As compensation, protection sellers demand a higher spread, thereby increasing the basis.
4. A Default Swap Protects Par
A default swap is a par asset--it compensates the protection buyer against the loss on a par value of the asset. Fixed rate assets which can typically trade significantly above, or below, par expose the investor to a greater/lower, credit risk than the same face value default swap. As a result, the credit spread of these assets should reflect the different credit risks. Bonds trading below par should pay a lower spread than default swaps while bonds trading above par should pay a larger spread than default swaps.
5. Counterparty Risk
A cash bond is a straightforward transaction between issuer and bondholder involving no other credit risk. However a default swap is a bilateral over-the-counter derivative transaction which is entered into with a counterparty. This adds the new dimension of counterparty credit risk to the default swap. Protection buyers will therefore tend to pay a lower spread as compensation against the risk of counterparty default. This reduces the default-swap basis.
6. P&L Realization
Unlike a bond that can simply be sold, locking in a gain or loss from a change in default-swap spreads typically involves entering into the offsetting transaction. However, since any net premium terminates in the event of default, the mark-to-market can only be fully monetized by waiting until the trade's maturity. This exposes the investor to default risk in the sense that if default occurs, the remaining spread payments terminate and any remaining P&L is lost. In return for this uncertainty, the investor requires a higher spread as compensation and hence that the basis should widen.
7. Asset Swaps
On default the buyer of an asset swap package loses the par redemption on the asset--receiving the recovery value of the asset only, and has an exposure to the mark-to-market of the interest-rate swap which may be in their favor or against them. This second risk does not exist in a default swap. Risk-averse asset swap buyers may therefore demand a slightly higher spread as compensation thus driving down the default-swap basis.
1. Technical Short
The majority of participants in the default-swap market are investors/risk-takers who want to sell protection in single-name-default swaps. More recently, this market has been reinforced by the growth in large synthetic collateralized debt obligation trades. Brokers hedge these structures by selling protection into the single-name default swap market, driving the market even further short and reducing the default-swap basis.
2. New Issuance
New issuance generally causes default-swap spreads to widen to make them more attractive relative to the supply of cash. The basis then starts to decline once all of the bonds have been placed. However, where large credit exposures are taken by banks in the cash market which are subsequently hedged in the default-swap market, this can drive up the default-swap spread and increase the default-swap basis.
3. Convertibles Issuance
Another market participant in the credit-derivatives market is the equity arbitrage funds who buy convertibles as a cheap source of equity volatility. They hedge out the credit risk in the default-swap market, thus driving out default-swap spreads and increasing the basis. Typically this widening of the basis is not sustained.
4. Demand for Protection
Due to the difficulty of shorting credit risk in the cash market, investors resort to the default-swap market. A negative market sentiment around the quality of a given credit can therefore have the effect of widening default-swap spreads relative to cash securities. The basis widens as a consequence.
5. Relative Liquidity
The liquidity characteristics of the cash and default-swap markets are very different. In particular the default-swap market is very liquid around the three-year and five-year maturity points while the cash market is only liquid at the maturity points of outstanding issues. Different parts of the credit curve behave differently and this can result in variations in the basis as a function of maturity.
As more investors use the default swap as a proxy for going long the credit risk, or as a new way to short credit risk, an understanding of the dynamics of the default-swap basis becomes more necessary. Furthermore, the default-swap basis can present new opportunities to relative-value investors.
This week's Learning Curve was written by Dominic O'Kane and Robert McAdie, directors in the fixed income research group atLehman Brothers in London.