Doubts over practice question - arbitrage trade and risk hedge

[Liming]

Dear David,
I’ve had some confusion, misunderstanding and doubts when doing 09 Level II Annotated Power Practice. Appreciate your kind help on this!
In your answer to the added question 2.12a under question 12, you answered that the market (interest rate) risk is not hedged against. However, my answer is liquidity risk because I think the interest risk has already been hedged against, given that the trader is short treasury.
Below is the question and answer for your reference:

Question 12:
Suppose the return on US treasuries is 3% and a risky bond is currently yielding 15%. A trader you supervise claims that he would be able to make an arbitrage trade earning 5% using US treasuries, the risky bond and the credit default swap. Which of the following could be the trader’s strategy and what is the credit default swap premium? Assume there are no transaction costs.
a. Go long the treasury, short the risky bond, and buy the credit default swap with premium of 6%. b. Go long the treasury, short the risky bond, and sell the credit default swap with premium of 7%. c. Short the treasury, invest in the risky bond, and sell the credit default swap with premium of 6%. d. Short the treasury, invest in the risky bond, and buy the credit default swap with premium of 7%.
[my adds] E2.12a. What major risk(s) is the trader *not* hedged against?
E12.12a. Interest rate changes (market risk) are not hedged by the CDS.

Thank you for your enlightenment and correction!
Cheers
Liming
16/11/09

 

[David Harper CFA FRM]

Hi Liming,

I don't think liquidity risk per se enters.

I intended to only make a point about the CDS; i.e., Interest rate changes (market risk) are not hedged by the CDS.
...however, I agree with you. I am imprecise here: it's not a mere basis trade. The short treasury hedges the market risk of the long bond. EXCELLENT! my mistake/imprecision...

David