Limits to Arbitrage due to Frictions and Regulation

Frederik Randrup Hansen

Student thesis: Master thesis

Abstract

This thesis examines the credit market arbitrage trade: The CDS-Bond Basis, and seeks to explain why it is possible to consistently observe nonzero bases and has been since the financial crisis. The main approach to this is to understand the mechanics and frictions of the trade as well as how the capital requirements imposed on the banking sector may affect the behavior of banks acting as arbitrageurs or as liquidity providers to market participants. We make a detailed outline of the balance sheet impact, regulatory impact and profit of the basis trade and do comparisons between trade characteristics like type of counterparty, credit rating of the underlying bond and weights on different capital requirements. We consider two cases; firstly, where the bank acts as the arbitrageur and secondly, where a hedge fund acts as the arbitrageur and need the bank to help facilitate the trade. In both cases, we calculate the return on equity and are then able to calculate the level of the basis at which the arbitrageur is willing to trade it considering a return target. We find that the basis must be considerably different from zero for either arbitrageur to earn the required return on equity and that the hedge fund has a harder time earning a return on the basis trade than the bank. Lastly we show that under a risk-weighted capital requirement, the basis on a poorly-rated underlying bond must be larger for an arbitrageur to trade it compared to a highly-rated underlying bond. This proves that not all bases are treated equal.

EducationsMSc in Advanced Economics and Finance, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2021
Number of pages69
SupervisorsDavid Lando