Brummelhuis, Raymond and Luo, Zhongmin
(2018):
*Arbitrage Opportunities in CDS Term Structure: Theory and Implications for OTC Derivatives.*

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## 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.

Item Type: | MPRA Paper |
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Original Title: | Arbitrage Opportunities in CDS Term Structure: Theory and Implications for OTC Derivatives |

Language: | English |

Keywords: | Arbitrage; Asset pricing; OTC derivatives; CVA; XVA; Valuation adjustment; Counterparty credit risk |

Subjects: | C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics C - Mathematical and Quantitative Methods > C4 - Econometric and Statistical Methods: Special Topics > C45 - Neural Networks and Related Topics C - Mathematical and Quantitative Methods > C5 - Econometric Modeling C - Mathematical and Quantitative Methods > C5 - Econometric Modeling > C58 - Financial Econometrics C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling G - Financial Economics > G0 - General > G01 - Financial Crises |

Item ID: | 94778 |

Depositing User: | Mr. Zhongmin Luo |

Date Deposited: | 04 Jul 2019 06:33 |

Last Modified: | 04 Jul 2019 06:34 |

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URI: | https://mpra.ub.uni-muenchen.de/id/eprint/94778 |