Explanation:
This represents a negative basis situation where the bond's credit spread (5%) is higher than the CDS spread (4%). To exploit this, an investor should engage in a negative basis trade by buying the bond (which offers higher credit compensation) and selling protection through the CDS (which provides lower credit compensation). This creates a synthetic position where the investor earns the higher bond spread while paying the lower CDS spread, capturing the basis difference.
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The current price of a company's 3-year bond implies a credit spread of 5%. A comparable 3-year CDS contract has a credit spread of 4%. To best exploit the mispricing, an investor can engage in:
A
a positive basis trade by selling the bond and selling protection through the CDS.
B
a negative basis trade by buying the bond and buying protection through the CDS.
C
a negative basis trade by buying the bond and selling protection through the CDS.