Unilever issues a 5-year bond with principal of 10,000 EUR that trades at par, has a fixed coupon rate of 'C' and recovers 40% in bankruptcy (which can only occur at the start of year 5). There is a market for 5-year CDSs with EUR 10,000 notional, which can be bought or written at a time-varying spread of S0.

Assume that arbitrage funds borrow at via the repo market, at a rate 'r_repo' which is typically 15 basis points higher than the LIBOR rate 'r_LIBOR'. Funds can also access 5-year interest rate swaps that offer a fixed swap rate of 'r_swap' in exchange for the floating rate r_LIBOR. Choose (assume) values of C, S0, and the various rates such that the CDS-Bond basis does not hold at t=0, and the optimal arbitrage strategy includes writing a CDS. Describe each position of the arbitrage strategy, and show the initial, interim, and final payoffs for each position.