In preparation for resuming our exploration of hedge fund trading strategies, we took a detour last time out to learn about bond futures and conversion factors, which are used in basis trading. Basis trading is a form of fixed-income arbitrage that seeks to benefit from a change in the spread between a spot bond price and an adjusted futures price. The formula for the basis is:
B = SP – (FP x CF)
B is basis
SP is spot price of bond (clean)
FP is futures contract price (clean)
CF is conversion factor
Clean prices are ones in which the present value of future cash flows, such as interest payments, are not included in the price. Normally, one purchases a bond at the dirty price, which includes such cash flows.
A bond basis trade is the simultaneous purchase and sale of a bond and a bond futures contract to capture a non-zero basis as profit. It is also known as a cash-and-carry trade. (There is an alternative method of achieving the same result using exchange of futures for physicals (EFP) which we’ll not discuss in this article).
The conversion factor is the key to a basis trade. Here’s how it works:
- If the basis is negative, the bond spot price is less than the adjusted futures price. In this case, you would “buy the basis” by buying cash bonds and selling futures contracts. Say that the conversion factor on the 8 ¾ T-Bonds of 5/15/2017 is equal to 1.077. To buy $100M of the basis, you purchase $100M face value of the bonds and simultaneously sell 1,077 (= $100M * (1.077 / $100K) of bond futures.
- If the basis is positive, the bond spot price is greater than the adjusted futures price. Here you would “sell the basis” by selling cash bonds and buying futures contracts. For instance, if the conversion factor on the 7 5/8 T-Bonds of 2/15/2005 equals .0960, then selling $10M of the basis would require selling $10M face of the bonds and buying 96 futures contracts.
To close out the trade, you need to purchase your short position and sell your long position. If you compare the opening spread with the closing one, the difference is the change in basis during the holding period. A narrowing spread favors the short position; a widening spread benefits the long.
If you think the spreads will narrow over time, you benefit from selling the expensive bonds and buying the cheap futures contracts if your prediction is correct. The change in basis over time is the cash part of the trade. The carry portion consists of coupon payments less financing costs (at the repo rate) for the bond (including accrued interest). You realize a profit if the sum of the cash and carry portions are positive.
Every 1/32 of a basis point is worth $31.25; on a position of $10M face, this equals $3,125. Therefore, if a basis narrows by 2.6 basis points, the short position profits on the cash portion of the $10M face trade by 2.6 * $3,125 = $8,125. As long as the short’s carry costs do not exceed $8,125, he/she will pocket a profit.
The risk in a basis trade is that the basis will move in an unfriendly direction due to a change in the yield curve, and/or the repo rate will change to your disadvantage. These changes are important because of the following reasons:
1) If the repo rate decreases, or if the yield curve steepens, carry and basis increases
2) A decrease in the bond’s yield relative to other deliverable bonds will increase the basis
3) Bond duration can affect a bonds response to yield changes: the basis of a low-duration bond will tend to rise with bond yields, whereas the basis of a high-duration bond increases when bond yields fall.
4) Volatility affects technical considerations involving the short’s strategic delivery options. A rise in volatility would tend to lower the futures price and raise bond basis.
There is extensive literature on basis trading, and interesting parties are urged to seek it out before embarking on any trading activity.
Our next topic will be asset swap trades.
While all hedge funds require financing, some perform their own clearing operations, while others hire a prime broker to perform administrative tasks. In today’s blog, we’ll discuss the three main administrative reports that prime brokers provide to their clients who are not self-clearing.
1) Financing – margin, securities lending, repurchase agreements
2) Administration – trade support, clearing and settlement, P&L reporting, cash management, procedure documentation
While all hedge funds require financing, some perform their own clearing operations, while others hire a prime broker to perform administrative tasks. In today’s blog, we’ll discuss the three main administrative reports that prime brokers provide to their clients who are not self-clearing. Typically, the accounting department of the investment fund will reconcile the information on these reports to its own internal data, and take steps to resolve any discrepancies.
Note that although the reports are generated monthly for accounting purposes, they are available daily and even in real-time to support trading decisions and cash management activities. Also, the term “report” is really a throwback to when access to this kind of information existed only as a computer printout. In today’s world brokers provide this data online and through decision support systems. Snippets (small subsets of information) are often available as text messages.
Reports can be generated on a trade date or settlement date basis. Trade date reports show positions and P&L based on when trades executed. Settlement date reports take into account subsequent settlement activity, including trade failures, loans/borrows, and repos.
The three vital reports are:
1) The Trade Date Position Report – reports the open positions for each account within a particular fund or business unit. Open positions can be long or short. The report usually tracks cost and market value (in both local currency and dollars), and calculates both unrealized and translation gains/losses. The market value for each security is usually arbitrated using price feeds from several sources. The difference between the cost and the market value of security’s open position is recorded as unrealized gains/losses and translation gain/losses in the financial statements. This price-update process is referred to as mark-to-market and is a required accounting procedure for companies whose primary business is trading securities. The Position Report gives traders vital information regarding risk exposure. In some hedging strategies, real-time positions and market values are used to maintain an arbitraged deal correctly. For example, in delta hedging, traders maintain an offset ratio of options to their underlying stocks. Price movements trigger hedge adjustments, and the ability to extract a profit from a delta hedge position requires that traders have access to very timely information, such as that provided from the real-time version of the Position Report
2) The Trade Date Realized Report - reports all realized gains/losses that have occurred during the selected time interval. Realized gains/losses result from the closing of a position, as opposed to unrealized gains/losses which result from the mark-to-market of an open position. Most systems calculate realized gains/losses on a first-in-first-out basis. Traders keep close tabs on the Realized Report, as it is an indication of the success or failure of a trading strategy – a prime determinant of trader compensation. Every trader has a vested interest in verifying the information in the Realized Report, especially if a clerical error understates a trader’s realized P&L.
3) The Cash Activity Report reports opening and closing cash balances for each trading currency by account and all the corresponding transaction entries that affect cash during the time period for which the report is run. This information is vital for the personnel who manage the trading firm’s cash. Cash managers are responsible for the optimal deployment of cash to minimize financial expense, maximize interest income, ensure adequate balances for upcoming expenditures, satisfy collateral requirements, and to make sure every last dollar (or euro or yen) is being put to good use.
Of course prime brokers can and do supply their clients with dozens of different reports, feeds, and screens. But the three reports we’ve described here form the information foundation that non-self-clearing hedge funds and other trading firms rely on from their prime brokers.