# Positive base arbitrage CDS vs Asset Swap

While I completely understand the negative base arbitrage when the base is defined as : $$Base = CDS - ASW$$ I am stuck on the possible arbitrage when the base is positive.
Let's think with an easy example :
France Telecom ASW : 100bps
CDS France Telecom : 200bps

I borrow the bond on a reverse Repo at Libor +30bps and sell it, and sell protection with the CDS. Then I receive 200bps from the CDS and pay Libor + 30bps for the repo and then ? I am not able to see the arbitrage ? Could someone provide some explanations ?

You sell the asset swap (i.e. short the bond and receive fixed in an interest rate swap) which means you are paying LIBOR + 100, and receive the repo rate from the reverse repo transaction that you used to finance the sale of the bond.

At the same time you sell protection, receiving 200 basis points. Your cashflows at each period are

$${\rm Cashflow} = {\rm Repo}- ({\rm LIBOR}+ 100) + 200 = 100 - ({\rm LIBOR} - {\rm Repo})$$

So whether this is a positive expected value trade or not depends on what repo rates are compared to LIBOR. Typically they are somewhat below LIBOR, which reduces the value of the arbitrage (e.g. if repo rates are 50 bps under LIBOR, your net cashflow is 50bps per year).

This explains why you don't really have an arbitrage - the combination of short asset swap and selling protection acts like a basis swap between LIBOR and the repo rate for the bond, and one way to view the CDS/ASW basis is as the par rate for this swap.

This also explain why positive basis is much more common than negative basis (since LIBOR is typically expected to be above repo) and why a negative basis is often considered as an arbitrage opportunity, whereas a positive basis is not.

I've also ignored several factors which tend to influence the basis to be positive rather than negative, including

• CDS premia are floored at zero, whereas asset swap spreads can be negative
• CDS contains an embedded cheapest to deliver option, which pushes premia up
• There is a demand for protection, and it is generally difficult to short cash, and , which pushes CDS premia up compared to asset swap spreads

On the other hand, there is also a demand for structured credit exposure (admittedly, less so now than before the credit crisis), and structured credit products often use CDS to provide leverage (rather than cash bonds, where it is difficult to get leverage for the same reason that it is difficult to short) which can tend to depress CDS premia compared to asset swap spreads. So the sign of the basis reflects the tug of war between these factors, as well as reflecting relative funding stresses in the repo and interbank market (expressed as the expected future difference between LIBOR and repo rates).