Arbitrage Opportunities in CDS Term Structure: Theory and Implications for OTC Derivatives

TL;DR

This paper establishes no-arbitrage conditions for CDS term structures, empirically identifies numerous violations indicating arbitrage opportunities, and discusses implications for OTC derivatives valuation and risk management.

Contribution

It provides the first systematic, model-free analysis of CDS-term-structure arbitrage conditions supported by extensive empirical evidence.

Findings

Identified 2,416 pairs of anomalous CDS contracts violating no-arbitrage conditions.

Demonstrated that such anomalies can lead to persistent arbitrage profits.

Showed that anomalies result in nonsensical default probabilities.

Abstract

Absence-of-Arbitrage (AoA) is the basic assumption underpinning derivatives pricing theory. As part of the OTC derivatives market, the CDS market not only provides a vehicle for participants to hedge and speculate on the default risks of corporate and sovereign entities, it also reveals important market-implied default-risk information concerning the counterparties with which financial institutions trade, and for which these financial institutions have to calculate various valuation adjustments (collectively referred to as XVA) as part of their pricing and risk management of OTC derivatives, to account for counterparty default risks. In this study, we derive No-arbitrage conditions for CDS term structures, first in a positive interest rate environment and then in an arbitrary one. Using an extensive CDS dataset which covers the 2007-09 financial crisis, we present a catalogue of 2,416 pairs of anomalous CDS contracts which violate the above conditions. Finally, we show in an example that such anomalies in the CDS term structure can lead to persistent arbitrage profits and to nonsensical default probabilities. The paper is a first systematic study on CDS-term-structure arbitrage providing model-free AoA conditions supported by ample empirical evidence.