Tutorial 9

Q1

• CDS Spread
  • Compensates the protection seller for the default risk of the reference entity
  • Holding a risky bond and the risk-free bond
• Risk premium is always $y-r$
• Market risk premium
• Yield of the risky investment, minus the yield calculated on government bonds
• Breakeven CDS spread should equal the risk premium
• Investors would be indifferent between holding thr risky bond and buying CDS protection or simply holding the risk-free bond

Factors meaning no arbitrage

• counterparty risk
  • CDS seller might not fulfil their obligations, the CDS spread could be higher than the bond yield spread
  • Leads to positive basis
• Bond liquidity
  • Bonds are less liquid that CDS contracts
  • Higher yield to cmpensate lack of liquidity, increases the bond yield spread and drives the basis lower (negative basis)