From a market risk perspective, selling a CDS looks a bit like buying a corporate bond and asset swapping it.

Because both positions leave you with just the residual credit spread exposure.

It is not surprising therefore that the market compares the price levels of these two trades.

We define the CDS cash basis as the CDS spread minus the asset swap spread, and in theory, especially when bonds are trading close to par, this basis should be close to zero.

The two trades are structurally different, so making a direct comparison can be difficult, but monitoring the CDS cash basis can give some information on whether the two markets are consistent with each other.

To give an example of what this means, let's imagine a negative basis scenario on a US corporate bond where the CDS is trading at 150 basis points and the asset swap spread is 200 basis points, giving a basis of negative 50.

In this case, it could make sense to buy the asset and the CDS.

Let's examine in detail how this trade would work.

You buy the bond and enter into a par par asset swap, paying, fixed and receiving, floating on the interest rate swap.

To leave you long a synthetic floating rate note with a coupon of sofa plus 200, you then fund the bond purchase by borrowing money in the repo market and paying the repo rate, which will almost equal sofa, and so those two components will cancel.

Once done, your only net cash flow is receiving 200 basis points per year.

You then buy the CDS at 150 basis points, netting 50 basis points per year.

If there is no default, you earn this 50 basis points in the event of a default.

The CDS pays your losses on the bond and the trades are unwound.

This example appears to be a risk-free profit opportunity.

In reality, it may represent a relative value opportunity, but is unlikely to be an arbitrage, particularly in the event of default when the effect of unwinding the interest rate swap would reveal up until now.

Hidden interest rate risk.