A new report from Finadium hashes out the tight similarities but critical differences between CDS and repo. These products share more interactions than financial professionals may think, including the recent trend of hedge funds selling off CDS to buy repo. Given the open-ended question of whether Greece’s restructuring will be a CDS credit event, the distinctions between and uses of the two products have been made clearer and more compelling.
One of the more interesting sections of the report is modeling changes to repo rates and CDS haircuts in order to understand the play between these variables and the profitability of the basis trade. Extrapolating from a 2007 model published by UBS, the report tests the impact of the following variables on Return on Capital:
• Interest Income on underlying bond on a spread to LIBOR basis
• LIBOR for relevant period
• Spread to LIBOR on bond financing
• Percentage of bond value financed
• CDS rate
• Collateral posted on CDS trade in percentage of face
The findings show the tight interrelationship between CDS and repo, and highlight how the introduction of CCPs will change the profitability of this investment model. According to the report, “CCPs act to mitigate counterparty risk, especially critical for someone buying CDS protection. There is little doubt that counterparty credit risk contributed to the demise of the basis trade and using CCPs to clear CDS trades will reduce the risk to any single participant (by mutualizing it).” On the other hand, higher or variable margin requirements on a CCP may make the basis trade unattractive in this new environment.
A link to the executive summary and table of contents of the report is here.