Limits to arbitrage and CDS–bond dynamics around the financial crisis

An ostensibly broken cointegrating relationship between CDS and corporate bond spreads during the financial crisis is restored once Libor/OIS spread is included as a third component. The three-variable cointegrating relationship derives naturally from the arbitrage strategy that practitioners implement to exploit differences between the CDS and the underlying bond spread, known as the basis. In the presence of limits to arbitrage, the cointegration error is associated with the profit and loss (P&L) of the basis trade, which is why we use it as threshold variable in a regime-switching VECM to describe the joint CDS–bond dynamics. The model shows better in-sample fitting properties than competing specifications, whilst it improves the out-of-sample performance of hedging dynamically the mark-to-market risk of corporate bond portfolios with CDS. We also document destabilizing dynamics in the CDS market during the crisis that originate in supply shocks in the corporate bond market.