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    Futures Flash Article1 en

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    - Negative basis occurs when the yield on the cheapest-to-deliver bond is lower than short-term financing rates, resulting in an arbitrageur taking a negative carry position by shorting futures and hedging with the bond - With the Bank of Canada rate at 0.25%, 10-year Government of Canada bond futures are unlikely to trade at negative basis until mid-2022, while some 5-year bond futures contracts could see negative basis as early as this year - Negative basis signals that the futures contract price must rise to compensate arbitrageurs for the negative carry on the hedged bond position, ensuring no risk-free arbitrage opportunity exists between the futures and bond

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    Futures Flash Article1 en

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    - Negative basis occurs when the yield on the cheapest-to-deliver bond is lower than short-term financing rates, resulting in an arbitrageur taking a negative carry position by shorting futures and hedging with the bond - With the Bank of Canada rate at 0.25%, 10-year Government of Canada bond futures are unlikely to trade at negative basis until mid-2022, while some 5-year bond futures contracts could see negative basis as early as this year - Negative basis signals that the futures contract price must rise to compensate arbitrageurs for the negative carry on the hedged bond position, ensuring no risk-free arbitrage opportunity exists between the futures and bond

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    - Negative basis occurs when the yield on the cheapest-to-deliver bond is lower than short-term financing rates, resulting in an arbitrageur taking a negative carry position by shorting futures and hedging with the bond - With the Bank of Canada rate at 0.25%, 10-year Government of Canada bond futures are unlikely to trade at negative basis until mid-2022, while some 5-year bond futures contracts could see negative basis as early as this year - Negative basis signals that the futures contract price must rise to compensate arbitrageurs for the negative carry on the hedged bond position, ensuring no risk-free arbitrage opportunity exists between the futures and bond

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    28 views3 pages

    Futures Flash Article1 en

    Uploaded by

    jalajsingh1987
    - Negative basis occurs when the yield on the cheapest-to-deliver bond is lower than short-term financing rates, resulting in an arbitrageur taking a negative carry position by shorting futures and hedging with the bond - With the Bank of Canada rate at 0.25%, 10-year Government of Canada bond futures are unlikely to trade at negative basis until mid-2022, while some 5-year bond futures contracts could see negative basis as early as this year - Negative basis signals that the futures contract price must rise to compensate arbitrageurs for the negative carry on the hedged bond position, ensuring no risk-free arbitrage opportunity exists between the futures and bond

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    Futures Flash Series

    ARTICLE 1

    MONTRÉAL EXCHANGE April 2021

    Forecasting/Understanding
    Negative Basis in Futures
    In normal circumstances, gross basis, the relative difference in price between physical delivery futures contracts and the cheapest-
    to-deliver (CTD) cash bond, is positive. In certain situations this price difference can become negative for entirely rational reasons;
    a situation that sometimes causes confusion among futures market participants and almost always results in questions seeking to
    understand the phenomenon.

    Gross basis
    To understand how this relative value can turn negative, we must first understand the definition and quoting convention for gross
    basis. In short, the gross basis is the price at which an investor can execute a cash-and-carry arbitrage trade by simultaneously
    buying a cash bond and selling a futures contract1, or vice-versa. The gross basis is defined below in Equation 1.
    EQUATION 1
    Gross basis = P – (F x CF)

    where: P = Cheapest-to-deliver bond price


    F = Futures contract price
    CF = Conversion factor for the bond

    On the delivery date for the futures contract, the contract and the bond are identical assets and, to ensure no-arbitrage conditions
    exist, must have an identical price; gross basis falls to zero at the delivery date, which is normally the last business day of the
    contract month.

    Positive gross basis


    In what most investors would refer to as normal circumstances, the yield curve is upward sloping with yields and coupons on most
    bonds higher than overnight financing rates. In this environment, an investor who has created an arbitrage position by buying the
    cheapest-to-deliver bond, borrowing cash to do so in the repo market and simultaneously selling the futures contract, has a positive
    carry position. Essentially, the investor earns the coupon on the bond, which is higher than the rate paid to borrow the cash used to
    buy that bond.
    Since the futures contract has no cash flows associated with it besides some nominal costs for margining the position, and the bond
    and futures contract positions will be identical within a few months when the contract reaches the delivery period, the contract
    should trade at a price that is lower than the bond price to ensure that this risk-free arbitrage yields only about the same as other
    short-term investments2. The amount that the futures contract is discounted relative to the price of the cheapest-to-deliver bond is
    called the gross basis, and reflects the amount of positive carry the investor would receive if s/he had done the bond trade instead.
    Figure 1 plots a theoretical gross basis, in the absence of any option value, for the scenario where a bond position purchased and
    financed to hedge a short position in futures contracts is positive carry. The bond will be delivered to settle the short futures contract
    on the last possible day so that the investor can reap the profitable carry for as long as possible, and the gross basis declines to zero
    on the last notice day for the contract (the vertical dotted line on the far right) when the two assets become identical.

    1 This arbitrage trade is referred to, understandably, as a futures basis trade.


    2 There are several embedded options in futures contracts. As option values are currently low and to simplify the concept of negative gross basis, we ignore them here
    with the exception of the timing option. Investors interested in the embedded options can refer to “Embedded Options in CGF and CGB Futures”

    1
    FIGURE 1
    Gross basis, no options
    0.6
    Gross basis ($)

    0.5

    0.366
    0.4

    0.3

    Positive Carry Scenario


    0.2
    Negative Carry Scenario
    1st Notice
    0.1
    Last Notice

    -0.1
    -0.09

    -0.2
    1 Apr. 2021 16 Apr. 2021 1 May 2021 16 May 2021 31 May 2021 15 June 2021 30 June 2021

    Negative gross basis


    Astute readers will have realized by now that, if an investor who bought the bonds to hedge a short position in a futures contract must
    give up some of the positive carry to ensure no-arbitrage conditions with an identical asset, then an investor who holds a negative
    carry bond position as a hedge to a short futures position must be additionally compensated in order to do the same. In the negative
    carry scenario, the relative price of the futures contract rises, so that the investor establishing a short position sells for a higher
    price. This higher price is demanded by the arbitrageur to compensate for the negative carry but results in the adjusted futures price
    exceeding the bond price and, based on the gross basis formula above, the gross basis then is negative.
    Figure 1 also shows a hypothetical scenario showing the behavior of gross basis over time when the bond position is negative carry.
    In that figure, the gross basis is negative and steadily rises by the daily negative carry until the first notice date3. The bond and futures
    contracts are identical on the first notice date in this scenario because, to escape the negative carry, the arbitrageur can, and usually
    will, deliver at the first available date. After the first notice date, the gross basis should be zero since the trade is a pure arbitrage; an
    investor can sell the contracts, buy the bond, and deliver the bond immediately to settle the futures contract obligation with no risk.

    Forecast for MX contracts


    While negative gross basis does not matter to some investors, the situation can sometimes come as a surprise to others. More
    specifically, investors who are habitually long futures contracts should be aware that the contract is expected to steadily depreciate in
    value by the amount of the carry on an associated bond arbitrage hedge.
    Given an understanding of how negative gross basis occurs, we can easily forecast when it will occur: when coupon rates of the
    cheapest-to-deliver bond are lower than short-term financing rates4. With the Bank of Canada holding the 0.25% target rate at least
    through 2022, according to recent statements, deliverable bonds will need a coupon that is lower than that rate5 to be forced into a
    negative basis situation. Figure 2 shows estimates6 for each contract until the end of 2022, with associated explanations below.
    FIGURE 2
    Trades at negative basis?
    CGB CGF CGZ
    M21 Highly Unlikely Possible Possible
    U21 Highly Unlikely Possible Possible
    Z21 Highly Unlikely Unlikely Possible
    H22 Highly Unlikely Unlikely Possible
    M22 Highly Unlikely Unlikely Possible
    U22 Possible Unlikely Possible
    Z22 Possible Unlikely Possible

    3 First notice date: the first day a short futures position (seller) may announce his intention to deliver the underlying instrument (cash bond) to the holder of the long
    futures position.
    4 Secured financing, i.e. term repo rates to the delivery date of the contract.
    5 This is a rule of thumb. In actuality, futures contracts could trade rich to bonds, forcing the price to a level that allows a small arbitrage and creating a negative basis
    situation, even though the coupon on a bond is the same as the short-term financing rate.
    6 Estimates only! Markets can anticipate Bank of Canada policy changes at any time, even if the Bank has indicated they will not be raising the target rate.

    2
    For 10y CGB contracts after M21, the 1.25% June 2030 bond will be the CTD until the U22 contract, which will have the 0.5%
    December 2030 bond as the CTD, becomes the active contract in late May 2022. By that time, short-term rates may have begun to rise
    and the CGBU22 contract could experience negative basis levels.
    For 5y CGF contracts, the 0.25% March 2026 bond is currently the CTD on the M21 contract, and will be for the U21 contract as well.
    Since the coupon rate is the same as the expected Bank of Canada policy rate to the delivery date, any richness in the contract could
    result in negative basis at any time7. In fact, M21 and U21 contracts can shift between positive and negative basis quite quickly,
    depending on market flows. It would appear at this time that the next 5-year bond, not yet announced, will have a higher coupon, so
    CGFZ21 will probably be a positive basis contract. The same scenario is expected for subsequent new 5-year bond issuances.
    A similar situation exists for the 2y CGZ contract, where the 0.25% February 1, 2023 bond is the current CTD on M21 contracts. Gross
    basis can be positive or negative, given the near equality of coupon levels and financing rates. The U21 contract will experience the
    same effect, since the CTD for that contract, the 0.25% May 2023 bond, also has a low coupon. New 2-year bonds, not yet announced,
    will probably also have a 0.25% coupon, so contracts beyond CGZU21 can potentially exhibit negative gross basis levels.

    7 Thus far, the exact opposite is true. Futures contracts have traded quite cheap relative to bonds such that Gross Basis has remained several cents above zero as of the
    end of March 2021.

    Kevin Dribnenki writes about fixed income derivatives and opportunities in Canadian markets. He spent over
    10 years managing fixed income relative value portfolios as a Portfolio Manager first at Ontario Teachers’
    Pension Plan and then BlueCrest Capital Management. During that time he managed domestic cash bond
    portfolios as well as international leveraged alpha portfolios and has presented at several fixed income and
    derivatives conferences. He received a BA in Economics from the University of Victoria, an MBA from the
    Richard Ivey School of Business, and holds the Chartered Financial Analyst designation.

    For more information


    T +1 514 871-3501
    irderivatives@tmx.com m-x.ca/futures

    Copyright © 2021 Bourse de Montréal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montréal Inc.’s prior written consent.
    This information is provided for information purposes only. The views, opinions and advice provided in this publication reflect those of the individual author. This publication
    is not endorsed by TMX Group or any of its affiliated companies. Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the
    information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This publication is not
    intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice. The information provided is not an invitation
    to purchase securities or derivatives listed on Montreal Exchange, Toronto Stock Exchange and/or TSX Venture Exchange. TMX Group and its affiliated companies do not
    endorse or recommend any securities referenced in this publication. CGB, CGF, CGZ, CTD, Montréal Exchange and MX are the trademarks of Bourse de Montréal Inc. TMX,
    the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.

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