I prepared this post after carefully reviewing Federal Reserve documents and CME publications. The goal is to break down the concept of basis trades in a simple and accessible way for anyone interested in understanding how Treasury futures and repo markets interact.
The basis trade bets on the difference between cash Treasury and Treasury futures prices by going long the cash bond and short the futures contract.
Basis trades are three-legged trades:
The cash bond is financed through the vast repo market. The profit is the price difference between the cash bond and the futures contract minus financing costs .
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You borrow money by agreeing to repurchase the bond later (repo).
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The lender gives you $9,980,000 and holds your Treasury bond as collateral.
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Cost = $99.80 × 100,000 bonds = $9,980,000
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You use the borrowed money to buy the bond.
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You sell futures contracts that match your bond position.
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This locks in your exit price of $100.00 per $100 face value.
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Expected proceeds at maturity = $10,000,000
You sell a Treasury futures contract — this is a standardized agreement to deliver a U.S. Treasury bond at a future date, at a locked-in price (e.g., $100.00 per $100 face value).
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So when you “sell the futures,” you’re agreeing to deliver a bond in the future in exchange for $100 per $100 of face value.
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You don’t deliver just any bond — you deliver the one that is cheapest to deliver (CTD) under the futures contract rules.
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During this time, you pay repo interest:
Interest=9,980,000 × 0.5% ×( 90/360) = $37,425
You deliver the cash bond you already bought into the futures contract you sold earlier.
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You bought the bond at $99.80
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You deliver the bond and receive $100.00 via the futures contract
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That $0.20 profit per bond is your “basis”
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Sell the Treasury bond by delivering it into the futures contract at $100.00.
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You receive $10,000,000 in return.
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You pay back $9,980,000 (principal) + $37,425 (interest)
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Total repayment = $10,017,425
$10,000,000−$10,017,425=-$17,425
✅ Now you’re not in profit! 🙂
The profitability of a basis trade depends on the difference between cash and futures prices of a Treasury. As the delivery date approaches, cash and futures prices converge. On the delivery date, a trader can buy a Treasury in the cash market and immediately deliver it into the futures market.
The profitability of basis trades is summarized by the implied repo rate (IRR), i.e., the repo rate at which the profit on the trade would be zero.
When the IRR is greater than the actual repo rate, basis traders can profit by “buying the basis,” that is, by buying the note and shorting the corresponding Treasury futures, while borrowing in the repo market.
The price gap between the bond and the futures contract closes over time, and that this “closing” (called convergence) happens faster than the cost of borrowing the money you used to buy the bond (the repo rate).
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Rollover risk: Interest rates on overnight repo are often lower than on term repo with the same collateral. But if you roll over daily repo, there’s the possibility of rising rates before the trade is complete. This would require more collateral for the same amount of financing. If you’re already leveraged, it may be hard to get more capital without selling assets at discounted or fire-sale prices. These sales could push prices down in other markets, causing more margin calls and a liquidity spiral.
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Margin risk: When Treasury note futures prices rise, the trader going long the basis will have to make variation margin payments on the short futures contract.
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Deviations of the IRR from the return on Treasury bills reflect the risks basis trades face. In the absence of rollover risk and margin requirements, the first two legs of the basis trade would be equivalent to a Treasury bill. In this case, the return on the basis should be the same as the return on that bill.
Investors rush to buy Treasury securities, driving up the spot price of Treasuries. This increase in spot prices will push the futures price higher as well.
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As spot prices rise, the cost of borrowing cash against Treasuries in the overnight repo market increases. This is because:
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Borrowers need to post more collateral (Treasuries) to secure the same amount of cash due to higher collateral requirements.
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Lenders demand higher compensation (higher overnight rates) for taking on counterparty risk in a stressed environment.
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When spot prices of Treasuries rise, their value as collateral becomes more volatile relative to cash. Lenders demand additional margin (collateral) to protect themselves against potential price swings.
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With fewer participants willing or able to trade futures due to higher margin requirements, the futures market may experience reduced depth and wider bid-ask spreads.
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This can lead to futures prices rising more slowly than spot prices, creating a divergence between the two.
Treasury spot price ↑
→ More volatile collateral
→ Lenders want more margin and more collateral
→ Repo interest rate ↑ (cost of borrowing cash ↑)
→ Futures trading harder (higher margin)
→ Fewer participants
→ Futures price ↑ slower than spot
→ Spot-futures divergence
Quantifying Treasury Cash-Futures Basis Trades, Link
OFR Brief Series: Basis Trades and Treasury Market Illiquidity, Link
https://www.cmegroup.com/tools-information/quikstrike/treasury-analytics.html
The Basics of Treasuries Basis, Link
