Consistency is also a relationship issue.We may know, for example, that when bad news is delivered, John always stays calm.However, lately he has “popped his cork” every time he hears of a production snag. We can no longer depend on John’s behavior and tend not to trust him to handle bad news—and perhaps stop bringing it.

Whether it is capital investment, expertise, or technology or process issues, both partners want to feel that the other is contributing equal value to the alliance. When one partner feels the other is not contributing at the same level he is, conflict may break out when he confronts the other about the lack of contribution, or he may stopcontributing to “get even.” Using your Partnering Intelligence is important when addressing the level of contribution. Failure to do this can result in a lack of trust in the partnership.

It is important for both partners to understand up front what each partner will contribute during the Explore Stage of Partnership Development. In reality, partners do not usually maintain the same level of contribution. Some partners may contribute in ways that are not recognized and valued by others. These contributions must be discussed in advance and acknowledged by all that they bring value to the alliance—otherwise, resentment and mistrust will surely develop.

Failing to do our part undermines the alliance. Rather than working to complete the task, time must be spent to rebuild the trust in the relationship. Over time, the partnership will dissolve because one party or the other will no longer find value in the relationship.

A primary reason partnerships are formed is to help us accomplish a task we do not have the skills to do ourselves. It is important that partners accurately assess their competencies and technical capabilities— both their strengths and weaknesses. When a partner is caught offguard by the other’s failure to deliver what he promised, this has serious repercussions on both the task and relationship elements of the alliance. It undermines the trust in the alliance and, consequently, the relationship.

You can make it work by understanding how to build trust and then taking the risks necessary to do so. This of course involves discussing the matter with your partner. It takes a two-pronged approach to discuss trust with a partner. First, you need to make a realistic assessment of your own ability to trust. Then you can turn to the trust level of your partner. You can start by assessing yourself first with the Personal Trust Assessment.

Understanding ourselves enhances our insights into our relationships. If you scored less than fifteen points on the assessment, think about it and talk about it. If your lack of trust involves what your partner did, discuss your concerns with your partner. Return to statement 3 and be specific: In terms of trust, exactly how does your partner’s behavior make you feel? Stick to behavior itself rather than what you think motivated it. Above all, avoid making assumptions about honesty, integrity, or ethical judgment.

Building trust should be an intentional activity. And since the development of trust is such an essential aspect of successful partnerships, organizations should support its development. This takes planning. When we are intending to enter a partnership, we must engineer our performance so that we’ll do what it takes to increase trust.When we care enough to plan, follow through, evaluate, and redirect our energies if necessary, we’re using our Partnering Intelligence.

Factors that widen the basis (positive basis):

• Strong demand from protection buyers such as banks or hedge funds
• Bonds can usually be funded in the repo market at or around Libor.
• If the bond becomes special the investor holds a repo market option that makes the bond more attractive than the CDS and tends to widen the basis (short positions in bonds cannot be locked in for years because of a nonexisting repo market).
• Deteriorating credit quality and increasing spreads/basis volatility or equity volatility (CDS = high beta instrument).
• Assets trading below par, that is an investor who pays $80 for $100 face value has less credit exposure than a protection seller at par. Therefore, the protection seller would demand a higher premium (spread) than the bond.
• Convertible bond issuance may lead to hedging credit risk to unlock “cheap” equity volatility.
• The cheapest to deliver option is a structural factor, which tends to widen the basis (protection buyer is able to deliver any qualifying loan/bond).

The default basis can also be viewed as a risk indicator. In general, the sale of default protection should be more attractive than purchasing a bond when the basis is high relative to the equity volatility of the firm and vice versa.

Capital structure arbitrage: These might be strategies where investors take a position in a default swap versus an equity put option. If equity is undervalued, CDS levels are tight and debt is rich the following strategy appears to be appropriate. For example, selling out-of-the-money puts versus buying protection allows to position for a rally in the stock/declining equity volatility and to “hedge” this opinion against the risk of the widening of spreads on the company’s debt. The option premium earned is used to fund the CDS, with positive or negative carry. It is important to realize that this is not a pure arbitrage or risk-free trade.

Factors that pull protection tighter (negative basis):

• Strong demand from protection sellers because of the unfunded nature of CDS and a lack of desired exposure/liquidity in the debt market.
• Synthetic CDOs can drive default swap spreads tighter because the manager needs to sell protection in order to buy synthetic credit risk into these structures.
• The existence of a default swap curve in 1, 3, 5 and 10 years can offer investors a broader range of maturities to construct a better portfolio.
• Assets trading above par, that is, the protection seller is exposed to a lower amount than the cash investor.
• Improving credit quality and decreasing spreads/basis volatility (CDS _ high beta instrument).

Senior versus subordinated CDS strategies: The senior-to-sub spread differential in CDS is driven fundamentally by expected recovery values. If senior spreads are half those of subordinated, then the expected senior loss following default is half that of sub. A 50 percent senior recovery (50 percent loss) would imply a 0 percent subordinated recovery (100 percent loss) A potential strategy is to sell subordinated protection and to buy senior protection (weighted). It offers the chance to unwind at a profit if the seniorto-sub ratio mean reverts to historical averages (positive carry trade). If a credit event occurs, the payoffs will reflect the actual relative recoveries in sub and senior debt.

Cash settlement (par minus market value) is the alternative to physical settlement and is used less frequently in standard CDS but overwhelmingly in tranched CDOs. The 2003 ISDA definitions further clarify the three types of credit events:

• Bankruptcy
• Failure to pay
• Restructuring.

Just like cash bonds or loans, CDS transfer credit risk. To remove the interest rate component of a cash bond, a synthetic floating-rate note can be created via an asset swap which eliminates the duration and convexity exposure of the cash bond. An unfunded position in the bond would have to be financed in the repo market. A CDS is equivalent to a financed purchase of a bond with an interest rate hedge (selling protection through a CDS or buying a corporate bond, asset swapping the coupon to floating and financing the holding in the repo market).

A steep credit curve implies a steep forward credit curve. A forward default swap is buying or selling protection for the given maturity at a given point in the future at the forward CDS spread. For example, Munich Re senior 2-year protection is at 21 bp and the 7-year protection trades at 34 bp. Selling 2-year protection and buying 7-year protection results in a 5-year CDS two years forward (2 _ 5 spread) at a level of 40 bp.