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.