Implementing Basis Trades

Understanding sources of risk for basis trades and where stress can manifest requires understanding the technical details of how these trades are implemented.

The basis — or the profitability of a cash-futures basis trade — is characterized by the implied repo rate (IRR), which reflects the cost of carrying the security (including financing costs) until the futures contract's expiration.

When the implied repo rate is greater than the actual repo rate, basis traders borrowing in the repo market can profit by buying the cash Treasury and shorting the corresponding futures. At delivery, the trader will earn the spread between the IRR and the repo rate. When the actual repo rate is greater than the implied rate, a "long basis" trade is not profitable.

The IRR is closely related to the yield on a Treasury bill because the cash flows from the basis trade replicate those from a Treasury bill maturing on the futures delivery date.

In particular, in times of relative illiquidity and high balance sheet costs, the implied repo rate has deviated significantly from the rate of return on bills.

One example of these deviations occurred following the collapse of Lehman Brothers in 2008 (see Figure 4 above). Immediately after that collapse, as liquidity dried up in financial markets, implied repo rates collapsed deeply negative across contracts. The IRR decline reflected a flight to safety in Treasury markets.

Because the futures price and the cash price of the Treasury are known to the basis trader, provided he also knows the repo rate, profits on these bets at delivery are guaranteed.

The basis trade does not, however, offer risk-free profits. Several risks threaten the profitability of the basis trade, and thus create potential consequences for financial stability.

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