Mispricing and Arbitrage in CDS Auctions

Two recent studies have found that the prices at which CDS auctions clear tend to differ substantially from both pre- and post-auction prices of the underlying bonds in the market. In particular, CDS "sell" auctions appear to result in systematic underpricing, and CDS "buy" auctions in systematic overpricing, of the bonds relative to market prices. In this article, using data on all auctions up to 2013, the authors confirm that these patterns hold and, indeed, that trading on this apparent mispricing between the market and the auction can generate paper arbitrage profits of 15% or more. They find, however, that these gains largely represent compensation for bearing liquidity risk.