  A negative basis trade enters a long bond position and buys protection on the
issuer of the bond through credit default swap (CDS), aiming at arbitrage
profit due to the bond-CDS basis. To classic reduced form model theorists, the
existence of the basis is an abnormality or merely liquidity noise. Such a
view, however, fails to explain large basis trading losses incurred during the
financial crisis. Employing a bond continuously hedged by CDS under a dynamic
spread model with bond repo financing, we find that there is unhedged and
unhedgeable residual jump to default risk that can't be diversified because of
credit correlation. An economic capital approach has to apply and a charge on
the use of capital follows. Together with the hedge funding cost, it allows us
to better understand the basis's economics and to predict its fair level.
