March 2009Vol. 1 No. 1

This is the first in what we hope will be a series of commentaries that we write from time to time for friends of the D. E. Shawgroup. We hope you find it helpful, and we encourage you to forward to us suggestions for improvements or future topics.

The Basis Monster That Ate Wall Street
Risk and Opportunity in the “Cash-Synthetic” Basis

T

HE
DIFFERENCE, or “basis,”
between cash financial instruments andtheirsynthetic,
derivative-based
equivalents was once a matter of interest
mainly to financial professionals involved instructured credit funds. But during the financial
crisis of the past year, cash-synthetic basis has
become so volatile and so pervasive across anumber of credit instruments that many have taken
to referring to it simply as “the basis,” even though
there are many other common forms of basis in
financial markets. (We similarly use this shorthandin this commentary.) Cash-synthetic basis hasachieved this notoriety for three main reasons:(1) it’s a nearly universal risk factor—even investors
that have no exposure to synthetic instruments are
effectively exposed to one leg of the risk factor;(2) its recent price movement has been massive;and (3) exposure to cash-synthetic basis is very
difficult to hedge.
How should investors incorporate cash-syntheticbasis analysis in their evaluation of such unsettled

financial markets? Observers of credit markets
have recently seen basis trades that, by historicalstandards, appear at first glance to be enormously
attractive.
But are we seeing fundamental
mispricings of credit, or something else altogether?
We thought it might be helpful to share ourviews on these and related questions. The firstsection of this commentary outlines how weevaluate the broader risk factors that largely
determine our exposure to cash-synthetic basis.
Subsequent sections delve into a few specifictrades for illustrative purposes, and explain how
we attempt to value different forms of cashsynthetic basis. For simplicity, we’re limiting
the discussion to the relationship between cash
bonds and related credit default swaps (“CDS”)
and interest-rate swaps. Although there aremany other forms of synthetic credit exposures,
CDS and interest-rate swaps are the mostwell-developed and common forms.

The Basis Monster That Ate Wall Street
Cash-Synthetic Basis:
The Underlying Risk Factors

Let’s begin with a basic definition of cash-syntheticbasis in the credit space: it’s the measure of thedifference between spreads on derivative credit
instruments 1 and spreads on closely matched (in terms of
issuer and maturity) cash bonds. 2 Simply put:
cash-synthetic basis = derivative spread – bond spread
The basis is said to be “positive” when the bond spread istighter than the synthetic spread, meaning that the bond risk
is priced more expensively than the related synthetic risk.
“Negative basis,” which is what we see on average in current

strictly fundamental terms. After all, the values of the two
instruments converge in the two most importantcircumstances: a default (when one instrument can literally
be converted into the other) and at maturity (when both
instruments cease to exist at a basis of zero in price terms).
That said, during the credit meltdown of the past year, wehave witnessed incredibly large swings in cash-syntheticbasis. Figure 1 shows cash-CDS basis for the J.P. Morgan
High-Grade Corporate Bond Index (“investment-grade
index”) and the J.P. Morgan High-Yield Corporate Bond
Index (“high-yield index”) over the past four years.
Before looking more closely at some examples of cashsynthetic basis, let’s step back and consider some of the

Cash-CDS Basis of Investment-Grade Index and High-Yield Index, 2005–2009
200
100
0

Basis (bps)

-100
-200
-300
-400
-500
-600
-700
-800
Jan-05

Jun-05

Oct-05Mar-06

Aug-06

Jan-07

Investment-Grade Index

Jun-07

Nov-07

Apr-08

Sep-08High-Yield Index

Source: J.P. Morgan

Figure 1

markets, is the inverse condition, when the derivative spread
is tighter than the bond spread, meaning that the bond risk ischeaper than the synthetic risk. Although the values of cash
bonds and CDS are subject to certain asymmetries (thefactors causing those asymmetries are discussed later in thiscommentary), the basis between a cash instrument and its
synthetic equivalent generally should be quite tight in

1

The use of “spread” is a bit of a misnomer in the context of credit
derivatives. It’s the industry term for referring to what is in fact not a spreadover anything, but instead is the coupon rate paid to the party providing thecredit protection. We use the term here in keeping with this convention.

2

The details of the calculation of a cash instrument’s spread are very
important for trading, but for the sake of brevity we omit them here.

MARKET INSIGHTS

Feb-09risk factors that should be kept firmly in mind when trying
to understand how the basis functions. Two factors are
particularly important: the terms and availability offinancing and the positioning of levered market participants.
Terms and Availability of Financing
The terms and availability of financing (which are perhaps
best understood as two sides of the same coin) are a primary
determinant of the level of the cash-synthetic basis.
When looking broadly at credit markets, demand for cash
instruments comes from both levered and unlevered
investors. For levered investors, demand for cash
instruments is partly a function of the terms and availability
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The Basis Monster That Ate Wall Street
of financing. When financing becomes more expensive
or more scarce, aggregate demand for cash instruments
decreases, which drives the basis in a negative direction. The
important terms in any financing are: (1) the initial margin
required on the financing, and perceptions of how marginlevels may change in the future (given that long-term assets
are often funded with short-term liabilities which are then“rolled”), (2) the term over which counterparties are willingto extend the financing, (3) the conditions under which that
financing may be terminated, (4) the rate that is charged forthe financing, and (5) the term and financing rate on
borrowed securities if the cash instrument is held short.
While each of these drivers needs to be considered
individually, it’s reasonable to consider them in the aggregate
for analytic purposes. This is mainly because they’regenerally correlated with each other—as overall financing
tightens, they all tend to deteriorate from the financing
customer’s standpoint, and as it expands, they all tend to
improve. In addition to these financing terms, the availabilityof financing also depends on the number of market
participants that have access to financing and the fact that
lenders can increase or decrease the availability of financing
based on perceptions of counterparty risk.
Positioning of Levered Players
Levered players include hedge funds, to be sure, but it’s
important to note that banks and dealers are generally
considered the quintessential large and heavily levered
holders of cash-synthetic basis risk. Banks and dealers
extend credit and other capital to clients, sell off some
portion of the risk, and hedge their remaining exposuresthrough various means, including synthetically via CDS on
single names and indexes. And in nearly all cases, they dothis using significantly more leverage than most hedge
funds. (Recently, capital losses, bond rating agencypressures, investor pressures, and changes in the regulatoryenvironment all have led banks and dealers to reduce theirleverage. In 2008, this process contributed significantly to thekind of liquidation scenario described in more detail below.)
One way of interpreting changes in cash-synthetic basis overthe past year is that the reduced availability of financing
simply caused the basis to move from one equilibrium state
to another by lowering demand for cash instruments. But it
seems to us that the pricing of the basis has gone beyond
equilibrium. Why has it done so? We believe the answer
relates to the initial positioning and subsequent deleveraging
of levered market participants. As the crisis began, many

MARKET INSIGHTS

levered investors were predominantly positioned long cash
instruments. 3 When the availability of financing decreased,
many banks, hedge funds, and other investors were forced todeleverage rapidly. The cumulative impact of the trading
costs or “slippage” these levered hands incurred in theprocess drove cash-synthetic basis more negative thanjustified solely by the fundamentals. Under a different set ofcircumstances, it’s possible that the positioning and trading
activity of levered players could have driven the basis morepositive for a group of cash instruments—for example, if thoseplayers were mostly short (rather than long) a certain group of
cash instruments and then had to reduce position size. (Seeour discussion of Berkshire Hathaway in the next section for a
specific example of the basis going more positive.)
Of course, the value and even the sign of the cash-syntheticbasis vary over time. If obliged to guess prior to the present
financial crisis, most market participants probably would haveventured that a basis position that was long the cash
instrument actually would have outperformed (that is, thebasis would have become more positive) in a crisis, as
worried investors would be expected to buy protection in theform of CDS, thereby pushing credit spreads on CDS wider
than those on the underlying cash bonds. A research reportissued by Lehman Brothers in August 2005, for example,
noted that “hedging demand amid increased market
volatility … kept CDS spreads wider relative to cash.” 4 But
events have unfolded very differently in this crisis. While thelong cash/short synthetic bases of a few issuers may haveoutperformed, that’s not been the case for the majority ofissuers during this now protracted financial crisis, and adecision to put on long cash/short derivative trades as a roughform of crisis insurance would not have worked out very well.
What’s critical here is that the two risk factors most
responsible for driving cash-synthetic basis—namely, theavailability of financing and the positioning (long or shortcash relative to synthetic) of levered players—are quite

3

This “long cash” bias among levered players is a normal condition forseveral reasons too complicated to detail here, but which include: (1) manyof the perceived market inefficiencies that levered players seek to exploit
relate to more “off-the-run” instruments (which often are cash instruments),
while synthetic instruments are mostly based on more plain vanilla products;(2) synthetic short positions are less margin intensive than are cash shortpositions; (3) financing costs and loss of borrow on synthetic shorts are, atleast superficially, less problematic than on cash shorts; and (4) an investor
seeking to profit by buying at a discount in the primary market and selling
later in the secondary market will be structurally long cash instruments.

4

Lehman Brothers, “CDS Basis Update: Positive Basis Opportunities,”
August 24, 2005.

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The Basis Monster That Ate Wall Street
inconveniently also two of the least desirable risk factors for alevered investment vehicle like most hedge funds. Those
factors’ combined impact literally describes the terms of aclassic common-investor liquidation crisis. By incurring heavy
exposure to financing risk and the portfolios of other levered
investors, a levered hedge fund is effectively selling a gigantic
put option on its ability to finance its own positions.
Moreover, this put option has characteristics that greatly
increase the probability that the option will move in themoney at the worst possible moment. If a levered investor
suddenly finds itself facing heavy losses, it’s not a stretch tosuppose that, at the same time and for largely the same
reasons, that investor’s equity capital base is under pressure
from redemptions, its financing position is weakening
because of a credit crunch, and other similarly positioned
investors are liquidating. Worse still, all of these phenomena
tend to self-reinforce in pernicious ways. In suchcircumstances, it’s imprudent to count on financing andtrading counterparties to provide help because, as alreadynoted, they’re likely to be deleveraging at the same time.
We generally attach a very negative value to this commoninvestor liquidation risk given that: it can pose an existential threat to many hedge funds;
 it’s a risk that’s common to a variety of investment
strategies and thus requires constant diligence to size at an
acceptable level, particularly because the various forms ofcommon-investor risk tend to become highly correlated ina liquidity crisis; and it’s an exposure that’s relatively easy for the underlying
investors in hedge funds to obtain at low cost, if theywant it.
We try to generate profits by focusing on the highest
value-added alpha we can find, rather than by accumulating
exposure to potentially destructive risk factors simply because
they may be easy to find and implement. (In fact, it’s the very
ease of obtaining some factors that makes them so potentiallytroublesome.) In that vein, let’s now turn to how we evaluate
specific cash-synthetic basis trading opportunities.

Evaluating Cash-Synthetic
Basis TradesEvery day we manage portfolios that explicitly or
implicitly have this form of cash-synthetic basis risk,
and in some cases we have an actual view, as a

MARKET INSIGHTS

profit-seeking, “alpha” matter, on the size and direction ofthat basis. In that respect, cash-synthetic basis creates
something of a dilemma. As noted in the previous section,basis trades potentially expose levered funds to some highly
lethal forms of risk. But the difference in pricing between
cash instruments and their synthetic equivalents may itself be asign of profitable trading opportunities. How can we capitalizeon these situations while remaining vigilant as risk managers?
Evaluating the risk/return characteristics of cash-syntheticbasis trades is very difficult because the initial positioning andtrading activity of levered market participants plays such alarge role in determining that basis. The positioning andbehavior of levered players can cause basis to vary (even insign) from one asset to another, even when those
instruments are otherwise quite similar. As a result,aggregate data on the market positioning and recent trading
activity of those players is extremely valuable information.
Unfortunately, this information is generally unavailable.
While we can and do attempt to collect market color andbelieve that we generally have relatively good intelligence
about the positioning of other levered players, given thesomewhat translucent nature of the system we all operate
in—neither perfectly transparent nor perfectly opaque—that information cannot be gathered with sufficientconsistency or rigor to serve by itself as a valid foundation
for price forecasting.
Even under the best of circumstances, attempting to
generate alpha in cash-synthetic trades may befundamentally at odds with efforts to control the attendantrisk. If cash bond A trades with a basis of -400 basis points(“bps”) and a different bond B of similar credit quality tradeswith a basis of -50 bps, an investor might be tempted tobelieve that the following trade would yield 350 bps of alpha(before any leverage is applied) while remaining neutral to
cash-synthetic basis: go long cash bond A and buy CDS
protection on A, and short cash bond B and sell CDS
protection on B. But the idea that you’ve controlled risk byremaining neutral to cash-synthetic basis turns out to be anillusion. While, technically, both the A and B legs of the
trade have the same PV01 5 exposure to the difference
between each of A’s and B’s cash-synthetic credit spreads(i.e., exposure to a one basis-point change in the difference
between the two credit spreads), they may in practice have

5

PV01 is the present value impact of a one basis-point move in an interest
rate or credit spread.

March 2009 | Vol. 1 No. 1 | Page 4 of 9

The Basis Monster That Ate Wall Street
very different betas to the cash-synthetic basis risk factor,
with possibly unhappy near-term consequences for theinvestor making this trade. For example, the investor might
be unpleasantly surprised to observe that the basis level of-50 bps in its short cash bond B position remains unchanged(or, worse still, even goes positive) while the -400 bps of basis
in its long cash bond A position, which might be wide simply
because it’s commonly held by a number of hedge funds,
simultaneously blows out to -800 bps because of liquidationpressures. This sort of thing can and does happen as a resultof the technical forces created by whomever happens to be
selling, and the reasons behind their transactions.
While technical pressures obviously affect many market
dynamics, we believe they are unusually profound in the caseof cash-synthetic basis risk. Unlike stocks and other
instruments that are driven at least in part by market“fundamentals,” basis is driven almost purely by technicalfactors. This makes life complicated. With respect to mostother forms of risk, we can often preserve alpha and mitigate
exposure to a risk factor by entering into multiple trades,
each of which not only has expected alpha but also has, forrisk management purposes, risk exposure that at least
partially offsets the exposures of the other trades. But that
isn’t so easily accomplished in the case of the cash-synthetic
mismatch. In fact, any attempt to do so could just as easily
increase risk as decrease it. Thus, we often view the best
course of action as simply refraining from getting too big in
cash-synthetic trades in the aggregate.
Consider the cash-synthetic basis of bonds issued byBerkshire Hathaway Inc. (“BRK”). During June and July of
2008, those bonds typically traded with a basis of less than
+50 bps. But in subsequent months, a combination of two
conditions drove the basis more positive. The primary causeof the widening of this basis was that BRK, owing to its AAA
credit rating and skillful negotiation of derivative contracts,
almost never needs to post variation margin on its existing
derivative trades. When the value of these trades swings infavor of BRK’s counterparties, those counterparties take on
credit exposure to BRK equal to the amount that the position
had effectively moved in the money. As this situation
worsens, BRK’s counterparties seek to hedge their contingent
counterparty credit exposure by buying CDS protection on
BRK, a relatively more efficient hedging method that allows
duration and other features to be more accurately matched.
In the fall of 2008, this hedging activity widened BRK CDS
spreads to nearly +500 bps. The secondary cause of the

MARKET INSIGHTS

widening of the BRK basis was that cash investors, whilecertainly anxious to free up liquidity in their portfolios
generally, typically held on to their BRK bonds. Given BRK’s
AAA rating and perceived status as a defensive play in thecorporate debt market, cash investors remained for the mostpart quite comfortable with BRK credit, as reflected by thebonds’ relatively tight credit spread (not basis) ofapproximately +150 bps. So, with levered investors
essentially uninvolved in the credit, BRK bonds traded withsignificantly narrower spreads than the CDS, resulting in awidening of the cash-synthetic basis from +50 to +350 bps
between July and November 2008 (and more recently aswell). If we compare the cash-synthetic basis of BRK’s bonds
to the investment-grade index at the same point in time, wefind that the cash-CDS basis of that index typically traded ataround -30 bps in June and July and then fell below -200 bps
in November. Other AAA defensive credits, such as GE
Capital Corp. (“GE”), performed similarly to BRK during thisperiod, which supports our thesis that the basis of the debt ofAAA-rated companies exhibits similar characteristics for thetwo reasons cited in this paragraph. Figure 2 shows the
cash-CDS basis of the investment-grade index, BRK, and GE
over the past four years.
After the recent violent swings in basis, it could be argued
that the best way to hedge basis risk is to “overhedge” beta
by hedging, for example, the long market value of a portfolioof cash instruments with a somewhat larger short synthetic
index position. We question that view on both theoreticaland empirical grounds. The theoretical underpinning for thecase on overhedging beta is not clear and seems more like aclumsy overfitting of market events that transpired after
Lehman Brothers’ default. Moreover, one need only lookback at price movements in credit markets before thesummer of 2008 to see how this hedge would not have
performed very well. At the beginning of 2008, credit
spreads on the investment-grade index were approximately+95 bps and the cash-CDS basis was -60 bps. On March
16, the day before the rescue of Bear Stearns, spreads onthat index widened to approximately +235 bps, but the
cash-CDS basis moved positive to approximately +15 bps.
So in this case, the “basis hedge” would have moved in thewrong direction.
While our portfolios suffered from some exposure to basis
over the course of 2008, we attempted to keep that exposure
within reasonable limits and refrained from making an explicit
wager on that risk factor. By contrast, those who put on large
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The Basis Monster That Ate Wall Street

Cash-CDS Basis of Investment-Grade Index, Berkshire, and GE, 2005–2009
400
300

Basis (bps)

200
100
0
-100
-200
-300
-400
Jan-05

Jun-05

Oct-05Mar-06

Aug-06

Jan-07

Investment-Grade Index

Jun-07
Berkshire

If one does wish to pursue a given cash-synthetic basis
trading opportunity, selecting cash-synthetic basis trades in a
way that conserves financing is central to managing risk. In
general, a manager can seek to combine several predictionsof future relative price movements in various instruments, in aneffort to increase the proportion of genuine manager insight
relative to position size. Under normal circumstances, we havea strong preference for making investments that are expected tocontain multiple sources of alpha—that’s especially true whenaccess to financing is as precious as it is now. Putting on asingle trade that has the potential to pay off in several ways
gives us more bang for the financing buck and can thus help us
make more efficient use of a given balance sheet.
For example, taking a position in a convertible bond may
allow us to put on a cash-synthetic basis trade while
simultaneously exploiting alpha in the convertibility featureof the bond. A concrete example of recent vintage (fromFebruary 2009) might be Qwest Corp’s 3.5% convertible

MARKET INSIGHTS

Apr-08

Sep-08

Feb-09GE

Source: J.P. Morgan

Figure 2

explicit basis wagers or set up basis trades as long puts tohedge other risks are now lamenting those decisions.
Moreover, if credit markets were to experience a sustained rally
at some point in the future, we don’t believe—contrary to
accepted wisdom—that cash would rebound faster thansynthetic instruments. In fact, we believe that cash-syntheticbasis could move even more negative and put yet morepressure on some levered investors.

Nov-07that is puttable in November 2010. CDS protection on
Qwest’s bonds traded at +600 bps, and the straight(meaning non-convertible) bonds themselves traded at a
spread of +800 basis points. But the Qwest convertible bondwas even cheaper. If one priced the convertible by assuming
a credit spread of +800 bps (the full spread on the cashbond), the theory price was approximately 98.5 while themarket price was 91.5. So for the same amount of fundbalance sheet usage, buying the convertible bond instead of
the straight bond would potentially transform an annual gainof +200 bps on the basis trade into +550 bps of annual alpha(assuming a duration of two years on the convertible bond).
We believe our multi-strategy approach to investing offers
certain advantages in identifying and structuring trades thatlayer different forms of alpha as we seek to make the most ofbalance-sheet resources.

How Cash-Synthetic Basis May
Distort Perceptions of the MarketT

he signals sent by cash-synthetic basis reach the farcorners of the global financial system and have a
direct impact on the profits and losses of funds thatmark their securities to market. Yet it may be difficult attimes for observers to correctly interpret what those signals
mean, simply because sometimes the basis is tangled up withother factors. The occasional conflation of mostly unrelated
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The Basis Monster That Ate Wall Street
phenomena can severely distort perceptions of what exactly
the markets are implying about a given situation. We findthe most common form of this “conflation error” is thatinvestors simply look at the current market price of an
instrument, compare it to the theory price of that instrument,
and assume the difference is a fundamental mispricing,
without factoring into their analysis technical, financing, orother considerations. Let’s consider a couple of examples.
Some observers have claimed, for instance, that it defies logic
that many U.S. Treasury bonds have higher yields thanequivalent interest-rate swaps. For example, currently
12-year Treasury bonds yield about 60 bps more thanequivalent swaps. Someone might thus conclude, “Debt issued
by the U.S. government yields significantly more than swaps,
despite the fact that swaps are based on LIBOR, which is an
unsecured borrowing rate among banks—that’s totally crazy!”
We think a better interpretation is as follows: (1) Treasuries areindeed 40 bps better (i.e., lower yielding) than swaps becauseof better credit quality (and certain tax advantages), but(2) there’s an additional 100 bps of yield in long-dated
Treasuries because of an unrelated -100 bps of cash-syntheticbasis in very off-the-run Treasuries (12-year high-coupon bonds
in particular), resulting in Treasuries trading with yields 60 bps
higher than interest-rate swaps, as previously noted. Looking at
it that way renders the apparent Treasury vs. swap anomaly
much less remarkable, and indeed like something that could
easily become more extreme, or might move to having the
opposite sign, depending on how markets evolve and how
market participants are positioned and behave.
As an editorial sidebar, we note that, despite current
controversies about the transparency and settlement issues
surrounding CDS and other types of swap agreements, we
believe that swap markets have often priced in a “truer” level ofthe market’s fundamental view on a particular issuer’s credit risk
than that implied by prices of cash bonds (although we don’t
believe this will necessarily always be the case).
Here’s a second example. In the Treasury Inflation-Protected
Securities (“TIPS”) market, a large cash-synthetic basis might
mislead observers about the future inflation implied by themarket. Consider that in November 2008, 8-year asset-swap
spreads on nominal U.S. Treasuries were generally priced in
the neighborhood of +70 bps (in other words, the “normal”
way, with swaps yielding more than Treasuries) while 8-year
asset-swap spreads on TIPS were generally in theneighborhood of -130 bps. The result was a 200-bps
disparity in the cash-synthetic basis for two Treasury bonds

MARKET INSIGHTS

of roughly the same maturity. On a traditional reading of
the situation, future inflation expectations could be estimatedby subtracting the real yield on an inflation-linked bond fromthe nominal yield on a nominal bond. In this case, the yieldon the nominal bond was approximately 2.5% and the real
yield on the inflation-linked bond was approximately 3.5%,
implying a 1% annual rate of deflation over the next eight
years. But a more refined approach would break that difference
into two components: an implied annual 1% inflation over thesubsequent eight years (given asset swaps on TIPS) and a 200bps difference in cash-synthetic basis between nominal andinflation-linked bonds at that maturity. In fact, if we look backat the inflation-swap market at that time—a market without
cash-synthetic basis—we see that 1% inflation was exactly
what that market was pricing in (although that market is illiquid
enough that most observers do not look to it for implied
inflation). This example illustrates that understanding basis has
important implications for policymakers or anyone interested indiscovering what the market is implying about certain elementsof the future macroeconomic landscape, in this case inflation.

Asymmetries in the Fair Value ofBonds and Credit DerivativesWe’ve now considered a few “real-world” cashsynthetic basis examples for general purposes.
As a final exercise, let’s discuss some of the more
idiosyncratic elements of basis analysis. While cash bonds andsynthetic instruments like CDS obviously are linked in various
ways in theory, a number of interesting factors create
asymmetries in practice that should be considered whenestimating the fair value of either instrument.
 Nuances of CDS contracts and cheapest-to-deliver
option: Synthetic instruments do not perfectly match
related cash instruments. For example, when a credit event
occurs, the buyer of CDS protection can deliver any of theissuer’s bonds to the protection seller, not just the specificbond the buyer might have been protecting. This “cheapestto-deliver” option is a helpful asymmetry for a negative basis
position (where, by way of reminder, the investor has gonelong the cash bond and shorted the synthetic). In a few realworld cases, this delivery option has proven to be very
valuable. For example, when Fannie Mae and Freddie Mac
were put into conservatorship by their federal regulator, thecompanies’ bonds increased in value because of theperceived benefits of direct government support. Happily forinvestors with negative basis positions, the conservatorship
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The Basis Monster That Ate Wall Street
was deemed a credit event, meaning that not only did theyreceive a small payment as buyers of CDS protection, butthey also could deliver the cheapest bonds into the contract,resulting in a profit on both legs of the trade. This delivery
option can also be very profitably exercised in a
“restructuring” in which a company is able to force materialchanges upon all holders of a bond or loan when thecompany’s creditworthiness has deteriorated.
 Rights of the cash instrument: Whereas taking a longposition in a cash instrument confers certain rights upon
the owner, gaining the same exposure via CDS does notprovide the same rights to the seller of protection. The
owners of cash bonds or loans may be able to profit fromtheir ability to negotiate with the issuer of the bond or
loan. For example, loan holders sometimes can earn feesby waiving covenants or renewing a commitment.
Investors using synthetic instruments to get the same
exposure do not benefit from these events.
 Likelihood and timing of bond default: Because cashsynthetic basis is certain to go to zero in a default, one
should, all else equal, prefer basis trades in bonds that arelikely to default sooner rather than later since that will
result in an earlier realization.
 Likelihood and correlation of CDS counterparty default:
If we enter a basis trade in which we purchase a bond issued
by Financial Company A and then buy CDS protection on
Financial Company A from Financial Company B, we run therisk that Financial Company B will default before Financial
Company A. This would cause us to lose the protection on
our bond, and we likely would have lost some money on thetermination event. 6 We can try to reduce this risk by buying
CDS protection from the most creditworthy counterparties,
avoiding a high potential correlation between thecreditworthiness of the CDS counterparty and the bondissuer referenced by the CDS, and sensibly managing our
exposures to counterparties.
 Distortions of LIBOR: Standard cash-CDS basis
calculations implicitly assume that LIBOR is the6

The loss on the CDS would be limited to the amount that the CDS
moves in our favor between the last time it was marked to market andwhen it is replaced in the market. More generally, if a large financial
institution defaults, it’s quite possible that other financial counterparties
selling protection on that name will simultaneously go under andconsequently fail to pay on the CDS contract. However, if the CDS
moves against us, we must make good on the full amount, even if thecounterparty has entered bankruptcy.

MARKET INSIGHTS

appropriate risk-free rate to employ, meaning that it’s therate at which the market should discount risk-free cash
flows. It’s worth first pointing out that, even undernormal conditions, LIBOR is not in practice a “risk-freerate,” as it’s the rate at which the largest banks (which
are of course themselves not risk-free) lend to each otheron an unsecured basis. Also, LIBOR is set via asomewhat messy polling mechanism, and it’s possiblethat the outcome of that poll may not reflect the market’strue discount rate. If LIBOR is tighter than the market’strue risk-free discount rate by 100 bps, for example,
that may result in standard calculations showing anegative basis of 100 bps simply because the market
will use LIBOR + 100 bps when pricing a bond.
 Duration of trade: Generally speaking, a 10-year basis
trade would be attractive at a lower spread than a 1-yearbasis trade because the maximum loss (i.e., the bond goesto zero, and the CDS is worthless) is the same for both,and yet there is more upside in bond points if the tradenormalizes (moves towards zero basis).
 Borrow risk on bonds: When selling bonds and selling
CDS protection, a fee is paid to borrow the bond, andthere is the potential to lose the borrow on the bond, bothof which affect the fair value of the cash-CDS basis.

Concluding ThoughtsW

e hope that this commentary, thoughnecessarily limited in scope, has shed some lighton how cash-synthetic basis functions incontemporary financial markets. As a practical matter, we
believe that understanding, monitoring, and potentially
profiting from exposure to cash-synthetic basis requires both
depth and breadth in a manager’s investment capability. The
ability to conduct in-depth analysis by gathering andprocessing data on the availability of financing, thepositioning of other levered players, and asymmetries in thevalues of cash and synthetic instruments is clearly important.
But so too is a broader understanding of whether a givenbasis opportunity is unusual relative only with respect to that
asset class over time, or whether it also stands out at aparticular moment relative to opportunities in other asset
classes. We believe the D. E. Shaw group is well positioned
on both counts, given our size—in terms of both assets undermanagement and human capital—and the range of expertisethat we deploy across multiple asset classes.

March 2009 | Vol. 1 No. 1 | Page 8 of 9

The Basis Monster That Ate Wall Street
The views expressed in this commentary are solely those of
the D. E. Shaw group as of the date of this commentary. The
views expressed in this commentary are subject to change
without notice, and may not reflect the criteria employed byany company in the D. E. Shaw group to evaluate
investments or investment strategies. This commentary isprovided to you for informational purposes only. This
commentary does not and is not intended to constituteinvestment advice, nor does it constitute an offer to sell orprovide or a solicitation of an offer to buy any security,
investment product, or service. This commentary does nottake into account any particular investor’s investment
objectives or tolerance for risk. The information containedin this commentary is presented solely with respect to thedate of the preparation of this commentary, or as of suchearlier date specified in this commentary, and may bechanged or updated at any time without notice to any of therecipients of this commentary (whether or not some otherrecipients receive changes or updates to the information inthis commentary).
No assurances can be made that any aims, assumptions,
expectations, and/or objectives described in thiscommentary would be realized or that the investment
strategies described in this commentary would meet theirobjectives. None of the companies in the D. E. Shaw group;
nor their affiliates; nor any shareholders, partners, members,
managers, directors, principals, personnel, trustees, or agentsof any of the foregoing shall be liable for any errors (to thefullest extent permitted by law and in the absence of willful
misconduct) in the information, beliefs, and/or opinions
included in this commentary, or for the consequences ofrelying on such information, beliefs, or opinions.

MARKET INSIGHTSMarch 2009 | Vol. 1 No. 1 | Page 9 of 9