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The CDS spread pricing model uses “Risk free rate” to discount the PV and the Z-spread also uses “Risk free rate” to compute the spread. But the given example uses repo rate that comparing to Libor:

For “Negative Basis Trade”

  • Z spread = 100 bps
  • CDS spread = 40 bps
  • Repo rate = 2% or Libor plus 20 bps

Thus, long the bond to receive at 100bps and borrow from repo at 2% or Libor plus 20 bps and buy CDS protection at 40 bps.

$$100 - (40+20) = 40bps$$

Q: Why does this example use the spread over Libor instead of the spread over “Risk free rate” (SOFR, Secured Overnight Financing Rate) in order to be consistent?

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    $\begingroup$ This example (where did you find it?) is probably old and came before the use of SOFR. $\endgroup$
    – noob2
    Mar 10 '20 at 20:35
  • $\begingroup$ @noob2 I found on this paper “Trading the CDS basis by Moorad Choudhry”. But on his paper, he uses ASW spread instead of Z-spread. But it’s got me thinking tht CDS pricing model still uses a risk free rate anyway. $\endgroup$
    – user506602
    Mar 10 '20 at 20:55
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    $\begingroup$ jot.pm-research.com/content/2/1/79 2007 paper before SOFR , before LIBOR scandal. $\endgroup$ Mar 11 '20 at 1:29
  • $\begingroup$ @DimitriVulis So, does this mean everyone now uses SOFR? $\endgroup$
    – user506602
    Mar 11 '20 at 1:38
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    $\begingroup$ As of March 2020, no, we're still pretty far from everyone using SOFR. $\endgroup$ Mar 11 '20 at 17:00

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