Negative basis trade

A negative basis trade exploits an arbitrage opportunity created by a difference between the price of a bond and the price of a credit default swap (CDS) that hedges it.

If the payment for the CDS is less than the spread on the bond, then this means that holding both generates a risk free profit, provided that the maturities of the bond and the CDS match.

This difference, is very small, as is typical of arbitrage opportunities, and making a reasonable return by exploiting it usually requires gearing up the position, by margin trading. This is where things can go wrong, and has done spectacularly for many. If a margin call is made, then a seller may be forced to close the position. As there is no guarantee that the position will be in profit at any time before maturity, there may be a loss, and as the position is on margin, the loss may be very large.

Any forced selling before maturity may cause a loss. Bad market conditions may force many sellers to close similar positions at the same time, causing the market to move against them, increasing losses.

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