Would This Repo+CDS Strategy Work?
So, up front I admit that I have limited knowledge of the CDS market and even less of the repo market. But I thought of a strategy today that could hypothetically work with certain assumptions. The crux of the strategy is to attempt to locate inefficiencies in the CDS and Repo markets.
The strategy would be to purchase a high grade corporate bond, purchase a CDS and enter into a repo to replicate the transaction. The idea would be for the interest from the coupon to be in excess of the costs of the Repo and CDS and then replicate the position multiple times to get an attractive return with little risk.
For example, say we bought $100MM of a 5% A rated bond at par, bought a CDS on it for, say, 100 bps (annualized) and then entered into a repo on very conservative terms of 3.0% with a 20% haircut. We're generating 5mm from the coupon and paying 1mm for the cds and 2.4mm from the repo (0.03*80MM), leaving us with 1.6MM in cashflow. We then replicate the transaction with the 80MM we received from the repo.
So, I used a lot of assumptions here, most notably pricing. It seems logical to me that you could enter a repo agreement at a rate lower than the coupon on a bond due to credit enhancement, by providing collateral at 125% of the repo amount and the cds, it seems likely that the spread between the repo and a comparable treasury would be very tight. Adding the cds, depending on the cp, could by itself upgrade the bond in theory (similar to muni bond ratings vs. their underlying ratings). It's a play on the combination of inefficiencies through CDS and repo pricing and by levering up via the repo you effectively lock in a large return with virtually no risk, excluding the possibility of a double default of course. The strategy seems like it would work best in an environment with larger spreads, allowing the potential for more inefficiencies.
What I am unsure of is the term of repos. I know most are overnight, but aren't there term repo's as well for longer horizons (e.g. 1 or 2 years)? If not you would have interest rate risk on the bonds and repricing risk on the repo's. Also I am assuming the repo market is somewhat inefficient because of the uniqueness of them. If I am not mistaking they aren't standardized, so couldn't having the combination of an appropriate haircut, repo rate and cds pricing create enough inefficiencies to provide arbitrage opportunities. Also, I know the CDS market has became more efficient recently, but I assume there are still some opportunities.
I'm sure I am wrong in these assumptions, because if not you could create huge returns with virtually no risk and the market would recognize so quick that the opportunity would diminish quickly. I'm just curious where the flaw in this strategy is. If nothing else, I would think that creating a strategy using as many inefficient instruments as possible could create opportunities, right? Anyways, I'm a value guy and never really get interested in any derivative outside of equity options, but I thought of this today and was curious what was wrong with my thinking on it.
it's called a negative basis trade. and the cost of financing is incorporated into the difference in pricing of the instruments. so yes, it's possible, but like anything the inefficiencies are quick to disappear.
I believe that is the general idea you are pitching. There is a play for Basis trading but mainly short basis. There are factors that you need to take into account such as the cost of funding also but you are on the right track.
Yeah that's basically it. Thanks for posting that video!
Idk about repos, but as far as CDS inefficiencies you could also do an asset swap. Buy a bond and shed its interest rate risk by going into a pay-fixed interest rate swap. You'd be left with the credit risk of the bond, so if the margin on the receive-floating payments is greater or less than the relevant CDS spread, there would be an arbitrage opportunity. Not sure how well this actually works in practice because it ignores the counter party risk of the swap, and the liquidity premium of the bond... but that's the concept at least.
Consequuntur quae sit temporibus officiis ipsa impedit accusantium. Non sequi libero eos saepe nostrum.
Ipsum illum hic labore dolor. A quos non harum dignissimos iste repellendus. Consectetur beatae numquam est est vel. Vero similique eaque aperiam. Veniam dignissimos cupiditate ipsa veniam nobis quam est.
Maxime neque rerum occaecati voluptatem quia dolorem cupiditate. Dolores vero in quod praesentium veniam. Atque libero perferendis omnis veniam quis eos natus laboriosam. Nesciunt ullam laboriosam ut neque quos earum dolores. Eveniet quia voluptas rerum qui commodi.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...