A novel approach for testing the parity relationship between CDS and credit spread

We test the CDS-credit spread arbitrage by taking into account the presence of an unobserved common factor structure driving the movement in the prices. We examine 193 European CDS-Bond basis from January 2007 to December 2009. We estimate one and two common factors for the corporate bond spreads and the CDS premia, respectively. We address the issue of cross-member cointegration by adopting a novel approach. While standard cointegration techniques support the parity relation, the novel approach discards this hypothesis.