June 6, 2006

I always wondered why basis trades were called basis trades. Trust Harris to provide an explanation. In Trading & Exchanges, he describes how in the US commodities markets, the difference between the Chicago wheat futures price and a local cash wheat price is the local basis. The futures price is the base price, and the difference with the cash price, the basis, reflects the cost of shipping the grain to the Chicago delivery point specified by the futures contract.

In fixed income, a basis trade is a two legged trade with a futures leg and a cash bond leg. Basis for EuroGovies is quoted on BrokerTec. An example trade would be buying the Sep 06 Eurex Bund futures contract, and selling one of the deliverable bonds for that contract.

If I short a bond futures contract, then to cover my position, I have to buy the bond for its later delivery. To buy the bond I need to borrow cash, which will cost me interest payments. That's the funding cost of the hedge. However, I will also earn the coupon payments on the bond – the accrued interest. So in this example, the equivalent of the wheat shipping cost is hedge cost: the cost of funding minus accrued interest. When a trader judges that bond and future prices are out of line, they'll exploit that with basis trades. And BrokerTec is one place they can do both legs as a single trade.


2 Responses to “Basis”

  1. AC Says:

    are there any other electronic exchanges that enable one to do basis as one transaction besdies broketTec? [i assume that this is so one doesn’t get caught with an unlifted leg up]

    do these markets maintain a seperate “spread market” quote book, with its own que, or does the ECN server constantly monitor the legs and just execute when the bid/asks on the outrights of the legs line up with the desired spread level . . .?

    and would an ECN ever get in a paradoxical situation like :

    “my outright on ”X” was at the head of the que, but the damned ECN executed another guy ahead of me because he was spreading ”X” against ”Y”

  2. etrading Says:

    Eurex and eSpeed do basis too. I don’t remember any of our traders complaining of getting only one leg of a basis trade – so I’m guessing the ECNs implement a separate book for basis as opposed to outrights for the future or cash bond, specifically to avoid the issue you outline.

    But we do have issues when we roll the front future contract internally at a different time to any of the ECNs doing basis…

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