Basis Trading
Basis trading is an arbitrage strategy usually consisting of the purchase of a particular security and the sale of a similar security (often the purchase of a security and the sale of a corresponding futures contract). Basis trading is done when the investor feels that the two securities are mispriced with respect to each other, and that the mispricing will correct itself such that the gain on one side of the trade will more than cancel out the loss on the other side of the trade.
Here basis trading is defined as trading cash bonds vs bond futures contracts. The following mathematical relationship exists between the price of a deliverable bond and the futures price:
Price of a bond future = Price of a bond today + cost of financing (repo)
This is a mathematical equation, which states that the price of a bond at any future date (a futures contract) equals the price of the bond now plus the cost of financing that bond from now till the future date. Thus, a discrepancy in any of the three variables provides a risk-free opportunity to make money.
EXAMPLE: A basket of bonds deliverable into the EURO BUND (LIF) contract deliverable on 10 September 2004. This is depicted on Bloomberg.
Used with permission for illustrated purposes only
The most important column in the table is the one headed 'Implied Repo Rate'. In this case, the dealer can buy the DBR 4.25 01/14 for 101.042 on 5 August 2004 and sell it via the futures contract on 10 September 2004 for 114.84. Notice that the dealer has basically structured a 31 days reverse repo trade where he reverses in bonds on 5 August 2004 and sells them back on 10 September 2004. The return to the dealer on the cash loan he has just made is the implied repo rate or 0.88%.
The basis arbitrage will only work if the dealer can now repo (finance) the bond he has just purchased till 10 September 2004 at a lower rate than 0.88%. In this example, the repo rate for 14 January 2005 bunds is 2.08%. There is no arbitrage unless the dealer can find someone willing to lend cash at 0.88% or below. In reality, the implied repo rate will always be lower than the actual repo rate, otherwise everyone would buy bonds and sell futures (ie effectively buying the basis) until the price anomaly disappeared.
The implied repo rate is equally important when selling the basis (ie buying futures, shorting bonds and borrowing them via the term repo market). Hence, it may be argued that basis trading is practically repo trading by another name.
