Preface xiii

About the author xix

1 Bond Futures Contracts 1

1.1 Introduction 2

1.1.1 Contract specifications 4

1.2 Futures pricing 11

1.2.1 Theoretical principle 12

1.2.2 Arbitrage-free futures pricing 16

1.3 Hedging using bond futures 21

1.3.1 Introduction 21

1.3.2 Hedging a bond portfolio 26

1.3.3 The margin process 31

1.A Conversion factor for the long gilt future 34

Selected bibliography 38

2 The Government Bond Basis 39

2.1 An introduction to forward pricing 41

2.1.1 Introduction 41

2.1.2 Illustrating the forward bond basis 43

2.2 Forwards and futures valuation 46

2.2.1 Introduction 46

2.2.2 Forwards 47

2.2.3 Futures 49

2.2.4 Forwards and futures 50

2.2.5 Relationship between forward and future price 52

2.2.6 The forward-spot parity 54

2.2.7 The basis and implied repo rate 57

2.3 The bond basis: basic concepts 60

2.3.1 Introduction 60

2.3.2 Futures contract specifications 62

2.3.3 The conversion factor 67

2.3.4 The bond basis 75

2.3.5 The net basis 78

2.3.6 The implied repo rate 82

2.4 Selecting the cheapest-to-deliver bond 92

2.5 Trading the basis 94

2.5.1 The basis position 94

2.6 Exercises 97

Selected bibliography 100

3 Basis Trading and the Implied Repo Rate 103

3.1 Analysing the basis 104

3.1.1 No-arbitrage futures price 105

3.1.2 Options embedded in bond futures contracts 110

3.2 Bond delivery factors 112

3.2.1 The cheapest-to-deliver 112

3.2.2 Selecting delivery time 114

3.2.3 Changes in CTD status 117

3.A General rules of the CTD bond 119

3.B A general model of the CTD bond 121

Selected bibliography 122

4 The Fundamentals of Basis Trading 123

4.1 Rates and spread history 124

4.1.1 Net basis history 124

4.1.2 The implied repo rate 128

4.2 Impact of the repo rate 129

4.2.1 The repo rate 130

4.2.2 Short bond position squeeze 134

4.3 Basis trading mechanics 136

4.3.1 Using the conversion factor 137

4.3.2 Trading profit and loss 138

4.4 Timing the basis trade using the IRR 139

4.4.1 The implied repo rate (again) 139

4.4.2 The IRR across futures contracts: Bloomberg illustration 143

Selected bibliography 145

Appendices

A Repo Financing and the Concept of the 'special' 147

A.1 Classic repo 150

A.2 Basket repo: Illustration using Malaysian government bonds 151

A.3 Special bonds in repo 155

B Relative Value Analysis: Bond Spreads 159

B.1 Swap spread and Treasury spread 161

B.2 Asset-swap spread 163

B.3 Z-Spread 165

B.4 Cash-CDS basis 169

References 173

C Liffe Long Gilt Delivery History, March 1996 to June 2001 175

Glossary 199

List of abbreviations 227

Index 229