Basis Trade?

[Gram]

Hey Guys!
I have confusion on the basis trade topic in derivates. I just cant understand that logic between that of a bond and CDS…if we have a bond with coupon 7% and LIBOR 2.5% and CDS is priced at 4.25% …how are we earning .25% profit. (i understand that Bond priced at 4.50% (7-2.5) and difference is .25% between CDS and Bond) But what is the logic behind going long on both and how are getting the profit in practical terms.
Thanks

 

[bfry]

Can you provide more details or where you are seeing this in the text? I am not sure what you are referencing but I think you mean the bond is trading at par (YTM of 7%) and the CDS is priced at 4.25% then you would be making a risk free profit of 25 bps by going long both of them and here is how.
Purchase the bond at a YTM of 7% and also purchase CDS protection at 4.25%. Therefore you have 0 credit risk - it is complete hedged. You are earning 7% on the underlying bond and paying 4.25% to hedge out your credit risk through the CDS. Therefore you are left with a spread of 2.75% on this trade when the risk free rate represented by LIBOR is 2.50%. Therefore the riskless profit is the 25 bps.
I believe this is what you are getting at.

 

[Gram]

You got my point. Thanks!