A company's five-year CDS trades at 300 bps while its bond trades 360 bps over the swap curve. How do you construct the basis trade, what does it carry, and what can make it lose?

Buy the bond and buy five-year protection: the package earns 360 minus 300, a basis of 60 basis points, and about 35 after funding at swaps plus 25, Rs 35 lakh a year on Rs 100 crore. On 15% haircut capital that is 2.3% a year. It loses if funding costs rise, if the basis widens, worth about Rs 4.95 crore on a 140 basis point move, if the protection seller fails, or if the bond is not deliverable.

Think of buying a car and a comprehensive insurance policy on it, then renting the car out. If the rent exceeds the insurance premium, you earn the difference and a crash is the insurer's problem. The bond pays 360 over swaps for bearing Ketaki's default risk; protection on that same risk costs 300, so the market prices one risk two ways, 60 basis points apart. The basis is the CDS premium minus the bond spread, -60 here, a negative basis. The trade buys the cheap risk and pays for protection: own the bond, swapped to floating, and buy protection on the same notional. If Ketaki defaults, Anshukam delivers the bond and receives par, and because the bond was bought at 98, that adds Rs 200 lakh.

Add the legs: +360 from the bond, -300 for protection, -25 for funding over swaps, so 35 basis points a year. On Rs 100 crore that is Rs 35 lakh a year, and because the repo lender keeps a 15% haircut, Anshukam's own capital is Rs 15 crore, a return of 2.3% a year over its funding cost. Small numbers like these are why basis desks run large notionals with borrowed money, and why the risks below matter far more than the carry.

Take them in order of how they actually hurt basis desks. Funding first: the trade needs repo every day for five years, and if the funding spread rises to 100 basis points the carry becomes Rs -40 lakh a year, while a higher haircut forces Anshukam to post capital or cut the position at the worst time. Second, mark-to-market: the basis can widen before it closes. With a risky duration of about 3.54, a move from -60 to -200 costs 1.4% x 3.54 x Rs 100 crore, about Rs 4.95 crore, 14 years of carry and a third of the capital. Both tend to happen together, in a credit crisis, when everyone with the same trade sells bonds to meet funding calls.

Then the contract itself. The protection seller may fail in the same crisis that makes the protection valuable, so the CDS counterparty and its collateral terms matter. The bond must be deliverable under the CDS terms: a bond that is subordinated, or issued by a subsidiary the contract does not reference, may leave Anshukam owning a defaulted bond with protection on a different one. A restructuring that the contract does not count as a credit event can cut the bond's value without triggering the CDS. And the interest-rate swap inside the asset swap survives a default and must be closed at market. A negative basis looks like free carry, but it is paid for bearing funding, counterparty and documentation risk.

It can be, on terms. Size it so that a widening to -200 and a funding squeeze together do not force a sale: here that means term repo for as long as possible, a position the capital can carry through a 140 basis point mark-down, and a protection seller with daily collateral. Check the deliverability of the exact bond against the CDS reference obligation before trading. The limitation: the -60 basis exists partly because the market prices exactly these risks, so the trade earns a fee for bearing them rather than exploiting an error.