Basic Questions About Basis Trades
I'm currently an undergrad with 0 practical experience, and trying to understand how treasury basis trades actually work. The questions might seem very stupid, but I figure I'll understand them faster by asking instead of thinking alone. I genuinely appreciate the help in advance.
- When buying the basis, I know the trader simultaneously long cash and repo the note out to finance the purchase. (Or I didn't understand this? I feel these 2 legs are just constructed out of nothing...) But, how does it work for selling the basis? My understanding is the trader shorts cash and use the proceeds to RRP a note, and then use that note as the collateral for the short cash position. This just feels wrong.
- For buying the basis, do people finance the long position on a o/n basis or on a term repo in practice (or something in between)? Assuming the profit from the basis trades is just the roll over risk and margin risk premium you earn on top the yield of a T-bill replicate, shouldn't the profit be then narrowed down to nothing if its financed by a term-matching repo?
- The 5y&2y IRR went negative during 08'/09' while the T-bill yields stayed well-above 0. I understand that this is because the flight to safety where the cash price went up to a point of backwardation and IRR then turned negative. But how should I interpret the negative risk premium over T-bill yields here?
- In a OFR paper, a chart shows under some circumstances, the GCF Repo rate can be higher than the FFR. I know GCF Repo reflects the wiliness to accept Treasuries as collateral - but how can a secured rate be that much higher than an unsecured rate? (The spread spiked to 60bps in 19')
Sorry again for the basic questions. And I genuinely appreciate if anyone can spare sometime to enlighten me or simply drop a link that can be helpful.
Hey there, no worries at all! There's no such thing as a stupid question, especially when you're eager to learn. Let's dive into your queries:
When selling the basis, you're essentially betting that the repo rate will increase relative to the cash bond yield. You would short the cash bond (borrow it and sell it), and then enter into a reverse repo agreement (lending money and receiving the bond as collateral). This way, you're positioned to benefit if the repo rate increases.
In practice, the financing of the long position can be done either on an overnight basis or a term repo, depending on the trader's view of the market and the specific strategy they're implementing. If the repo is term-matching, the profit wouldn't necessarily be narrowed down to nothing - it would depend on the difference between the repo rate and the yield on the Treasury.
The negative risk premium over T-bill yields during the 2008/2009 period can be interpreted as the market pricing in a higher demand for safety and liquidity. In times of market stress, investors are willing to accept a lower, or even negative, yield for the safety of holding Treasuries.
The GCF Repo rate can be higher than the Federal Funds Rate (FFR) due to various factors, including the quality of the collateral, the term of the repo, and market conditions. Even though the GCF Repo is secured, if the demand for high-quality collateral (like Treasuries) is high, the rate can exceed the FFR.
Remember, the world of basis trading can be complex, but with time and practice, you'll get the hang of it. Keep asking questions and seeking knowledge - that's the best way to learn!
Sources: Q&A: Rates & Macro Research/Strategy - Career Path, Technical Topics, Education, etc., https://www.wallstreetoasis.com/forum/asset-management/sales-trading-interview-guide-gekkos-guidance-part-2?customgpt=1, https://www.wallstreetoasis.com/forum/trading/qa-1st-year-bb-london-rates-trader-taking-your-questions?customgpt=1, CDS-Bond Basis - Any credit traders in here?
Good questions.
1. Exactly as you described. Both the repo and the cash trade occur simultaneously (or near enough). Most securities settle t+2 though, so you have 2 days before you actually need to wire the cash for the securities (which buys for you to line up the repo).
2. Something in between. Generally, you try to term out the repo as much as possible. A shorthand for the profit in the basis trade is the difference between the implied repo and actual repo + optionality in the contract.
3. Implied repo (or actual repo) being low or negative is indicative of collateral scarcity. I don't think you can take the idea of a "t-bill replicate" to the extreme because you need to think about the incentives of each participant For example, MMFs will never drive repo rates below t-bills by investing so much in reverse repo. That will only happen by hedge funds being very short or dealers trying to source collateral to cover their short --> using a t-bill as a comparison is irrelevant.
4. A couple things here. (1) Fed funds is a captive/negotiated market between the FHLBs on the lending side and FBOs on the other, so the rate in and of itself doesn't actually tell you that much. (2) GCF is a very small part of the repo market (c. $60bn daily I think vs. ~$3bn for the rest of the market). (3) GCF is also a different counterparty set than FF borrowing. GCF is interdealer and FF is interbank (only cptys with a Fed master account can borrow/lend fed funds). (4) The general spike in repo rates in 2019 was driven by participants trying to fund collateral - borrowing in FF doesn't help you fund your securities inventory or basis long.
You might find this diagram helpful: Mapping U.S. Dollar Funding Flows - FEDERAL RESERVE BANK of NEW YORK (newyorkfed.org)
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