The current developments in the credit or bond markets, influenced by the financial crisis and the economic downturn, revive a discussion about credit derivatives as an instrument of speculation and one cause or determinant of the financial crisis. Currently, CDS are used to speculate against the solvency of the different governments. Critics look at CDS contracts as Overthecounter (OTC) instruments that are not regulated and as bilateral contracts which can have a big influence on the financial position of market participants and on the real credit markets. CDS contracts are mainly instruments for investors to insure against a default of the debtor. For the seller of the CDS they are a possibility to participate in risks he perhaps could not have taken on the bond markets otherwise. These contracts separate the default risk of the debtor from the market conditions, e.g. the market interest rates. They make it possible to only trade the credit risk of a company or a country. Therefore, they can be instruments to proof the bond values and indicators for the real credit risk of the underlying. The discussion about CDS contracts is mostly a discussion including many prejudices and it deals with aspects from different topics which cannot be mixed. Therefore, a clear picture of advantages and disadvantages and especially values and risks of CDS is difficult to be found in the current public discussion and economic newspaper articles. A further phenomenon is that bond markets and CDS markets have lost their connection in the financial crisis. So the credit risk on both markets is valued differently: the prices on the two markets differed so much that market participants used these arbitrage possibilities to earn credit riskfree money for themselves and their customers It can be traded with a simple combination of the underlying bond and the fitting CDS contract. One of the causes of the basis can be the different liquidity level in the two separated markets. For the development of the basis during the crisis it is important to ask how big the changes are compared to the situation before the financial crisis and also how important the credit rating or the industry of the reference entity is.. The price difference, if the CDS price is lower than the credit risk priced by the bond of the same reference entity, is negative basiscalled
Table of Contents
- Executive Summary
- Problem Description
- Methodology
- Results and Assessment
Objectives and Key Themes
This master's thesis examines the negative basis in Credit Default Swap (CDS) contracts and its relationship to credit risk during the 2008 financial crisis. The study aims to analyze the role of CDS contracts in the crisis, assess their impact on credit markets, and investigate the phenomenon of the negative basis as a trading opportunity.
- The role and impact of CDS contracts during the financial crisis.
- The phenomenon of the "negative basis" and its determinants.
- Empirical analysis of the basis across different companies and industries.
- The implications of the negative basis for trading strategies and risk management.
- Regulatory aspects and future implications of CDS contracts.
Chapter Summaries
Executive Summary: This section provides a brief overview of the thesis, highlighting the problem of CDS contracts' role in the financial crisis, the concept of the negative basis, and the methodology used to analyze the data. It touches upon the findings, showing that CDS contracts didn't cause the crisis but played a role in risk transfer, and that the negative basis presented both opportunities and risks.
Problem Description: This chapter introduces the context of the study, focusing on the increased debate surrounding credit derivatives and their role in the financial crisis. It explains CDS contracts as instruments for hedging and speculating on credit risk, highlighting the disconnect between bond and CDS markets that led to arbitrage opportunities, particularly the "negative basis." The chapter emphasizes the lack of clarity regarding CDS contracts' advantages and disadvantages in public discourse and the need for a clearer understanding of the associated risks and values.
Methodology: This chapter outlines the research approach taken in the thesis. It describes the three main parts of the analysis: a theoretical overview of CDS contracts and their market dynamics, an empirical analysis of the negative basis for 24 companies over five years (March 2005 to October 2010), and a proposal for a trading strategy based on the negative basis. The empirical analysis tests three hypotheses concerning the basis's behavior during the financial crisis, considering credit rating and industry factors.
Results and Assessment: This chapter presents the key findings of the empirical analysis and discussion. It supports the hypothesis that the negative basis widened and turned negative for lower-rated companies during the crisis, while higher-rated companies showed less extreme movements. Differences in liquidity between bond and CDS markets are identified as a crucial factor. The chapter also analyzes the impact of industry-specific factors on the basis, highlighting the differences between stable and volatile sectors. Finally, it discusses the use of the negative basis for trading strategies and products, emphasizing both the potential for profit and the associated risks.
Keywords
Credit Default Swaps (CDS), credit risk, financial crisis, negative basis, arbitrage, bond market, CDS market, credit rating, liquidity, empirical analysis, trading strategy, risk management, regulation.
Master's Thesis: Negative Basis in Credit Default Swap (CDS) Contracts During the 2008 Financial Crisis - FAQ
What is the main topic of this master's thesis?
This thesis examines the negative basis in Credit Default Swap (CDS) contracts and its relationship to credit risk during the 2008 financial crisis. It analyzes the role of CDS contracts in the crisis, assesses their impact on credit markets, and investigates the negative basis as a trading opportunity.
What are the key themes explored in the thesis?
The key themes include the role and impact of CDS contracts during the financial crisis; the phenomenon of the "negative basis" and its determinants; empirical analysis of the basis across different companies and industries; the implications of the negative basis for trading strategies and risk management; and regulatory aspects and future implications of CDS contracts.
What methodology was used in the thesis?
The research employed a three-part analysis: a theoretical overview of CDS contracts and their market dynamics; an empirical analysis of the negative basis for 24 companies over five years (March 2005 to October 2010); and a proposal for a trading strategy based on the negative basis. The empirical analysis tested hypotheses concerning the basis's behavior during the financial crisis, considering credit rating and industry factors.
What are the key findings of the empirical analysis?
The analysis supported the hypothesis that the negative basis widened and turned negative for lower-rated companies during the crisis, while higher-rated companies showed less extreme movements. Differences in liquidity between bond and CDS markets were identified as a crucial factor. The impact of industry-specific factors on the basis was also analyzed, highlighting differences between stable and volatile sectors.
What are the implications of the negative basis for trading strategies?
The thesis discusses the use of the negative basis for trading strategies and products, emphasizing both the potential for profit and the associated risks.
What is the overall conclusion of the thesis regarding the role of CDS contracts in the 2008 financial crisis?
The thesis concludes that while CDS contracts did not cause the 2008 financial crisis, they played a significant role in risk transfer. The negative basis presented both opportunities and risks for market participants.
What are the key words associated with this thesis?
Credit Default Swaps (CDS), credit risk, financial crisis, negative basis, arbitrage, bond market, CDS market, credit rating, liquidity, empirical analysis, trading strategy, risk management, regulation.
What is included in the Table of Contents?
The table of contents includes: Executive Summary, Problem Description, Methodology, and Results and Assessment.
- Quote paper
- Matthias Schnare (Author), 2010, The negative basis - Credit Default Swap contracts and credit risk during the financial crisis, Munich, GRIN Verlag, https://www.grin.com/document/180389
