Inverted yield curve followed by 800-point plunge in Dow next day; how about inverted CDS curves?

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When the 5-year CDS rate (highlighted in red) crossed into 10-year CDS rate (highlighted in brown), an inversion of CDS curve took place., within no preliminary expenses, if one sells default defense at 5-year CDS rate (89.53 basis point) and buy default security at much lower 10-year CDS rate, one should expect persistent arbitrage revenues represented by the green line.

After a year of intensive research, the paper by Brummelhuis and Luo (2018) titled Arbitrage Opportunities in CDS term structure: Theory and Implicati… presents a summary of such an investigation based on 30+ million pairs of CDS trades to fill in the research gaps mentioned above. The paper derived the exact mathematical conditions governing the shape of a CDS curve in order to disallow arbitrage (CDS curve inversion is one of such conditions.), which leads to the findings of a large number of so-called arbitrage opportunities in CDS term structure, which turn out to lead to persistent arbitrage profits as illustrated below.

When the 5-year CDS rate (highlighted in red) crossed into 10-year CDS rate (highlighted in brown), an inversion of CDS curve happened. In the example below, when inversion happened first on 3 December 2008 (exactly 10-year ago!), within zero initial costs, if one sells default protection at 5-year CDS rate (89.53 basis point) and buy default protection at much lower 10-year CDS rate, one should expect persistent arbitrage profits represented by the green line. The calculation is based on standard CDS model used by banks. See the paper for more details.  

This concludes the summary regarding what motivates the research done in the paper #3 from the following four papers; please feel free to check out other papers below if interested. We welcome you to read and provide feedback for our research; if possible, please feel free to reference to our papers.

  1. CDS Rate Construction Methods by Machine Learning Techniques: Methodology and Results; Brummelhuis and Luo, forthcoming in peer-reviewed journal, 2018a
  2. CDS Rate Construction Methods by Machine Learning Techniques: Parameterization, Correlation and Benchmarking; Brummelhuis and Luo, forthcoming in peer-reviewed journal, 2018b
  3. Arbitrage Opportunities in CDS Term Structure: Theory and Implications on OTC Derivatives. Brummelhuis and Luo, SSRN journal, 2018c
  4. Bank Net Interest Margin Forecasting and Capital Stress Testing by Machine Learning Techniques. Brummelhuis and Luo, SSRN journal, 2018d (will be available soon)

   

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