What’s driving the default swap basis?

Viktor Hjort

INTRODUCTION

The significant growth seen in the credit default swap (CDS) market has been driven to a great extent by its role as a proxy for the bond and loan market. Although the default swap market adds value for many investors by providing access to credits not readily available in the cash markets, its main importance is as an instrument that allows investors to isolate credit risk from interest and funding risk.

This assumes that the exposure achieved through a default swap position replicates that of a similar position in the cash market, but stripped of interest rate and funding risk. However, in the market we frequently observe divergence, often significant, between the premium paid on a default swap and that paid on a cash instrument of the same credit and maturity. Here, we present an overview of the factors driving this basis and also analyse the relationship between the cash and derivatives markets at the market, sector and individual credit levels.

The default swap market is often perceived as driven primarily by technical factors, particular to this market only. We find little evidence to support this view. Instead, the nature of the markets argues for a close