1.1.1 Basis trading (cash versus futures)

The basis arbitrageur seeks to opportunistically buy or sell sovereign bond futures against purchasing or selling short a weighted basket of cash bonds. The cash bonds will be deliverable by virtue of the contract specifications as set by the futures exchanges (i.e. Chicago Board of Trade (CBOT), London International Financial Futures Exchange (LIFFE)). The arbitrageur will typically purchase futures and sell the cash bonds at spreads that are expected to profitably converge at delivery. Rarely does the basis trader wait until delivery to take a profit. Generally, they play the divergences or dislocations that occur during the quarterly delivery cycles.

Usually, until delivery, one would expect the relationship between the cheapest to deliver bond and the futures contract to track breakeven levels. Therefore, if the futures contract and the cheapest to deliver bond deviate, the dislocations would tend to be temporary. But as the yield curve changes the bond which is cheapest to deliver may shift to a different bond issue in the delivery basket. Therefore, a basis trader has market risk, as they might not be long and short converging assets. Changes in the overall level of interest rates or changes in the shape of the yield curve may also change the cheapest to deliver bond.

Hedge funds that include government bond basis trading as part of their portfolio will typically be highly levered. The margin requirements for this trade are quite small. Therefore, it is not...