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A six-year CDS on a AA-rated issuer is offered at 150bp with semiannual payments while the yield on a six-year annual coupon bond of this issuer is 8%. There is no counterparty risk on the CDS. The annualized LIBOR rate paid every six months is 4.6% for all maturities. Which strategy would exploit the arbitrage opportunity? How much would your return exceed LIBOR?
A. Buy the bond and the CDS with a risk-free gain of 1.9%.
B. Buy the bond and the CDS with a risk-free gain of 0.32%.
C. Short the bond and sell CDS protection with a risk-free gain of 4.97%.
D. There is no arbitrage opportunity as any apparent risk-free profit is necessarily compensation for being exposed to the credit risk of the issuer.
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