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ITXES21 Basis, New Docs And The AQR

14 October 2014 by lberuti

Because they feared CDS written using the 2003 documentation would become illiquid past the September roll, investors have favoured hedging the financial part of their portfolio with indices rather than single name CDS since the beginning of the summer. While activity on single names had slowed quite a bit up to September, the iTraxx Senior Financial index (the series 21, on the run at the time) was consistently bid. That led to a chronically positive basis between the index and its fair value. In other words the index risk premium was wider than its theoretical value based on the risk premia of its constituents. Now, the AQR results are in sight (they should be released in a few weeks) and the rumour has it that most banks will pass, and in any case all the tier one institutions will come unscathed. So investors have started to unwind their long protection positions on index series 21, leading to a correction of the basis over the last 10 days. That trend appears set to continue. Future protection purchases will take place on the series 22 which is cleaner in terms of documentation (all its constituents trade on 2014 docs, while banks in the series21 still trade on 2003 docs) and buyers of protection on the series 21 will be few and far between.