How Repo Financing Amplifies Treasury Basis Trade Returns

Summary

The document explains how repo financing can make a small Treasury cash-and-futures basis return attractive. The relevant comparison is between the implied financing rate embedded in the bond-futures trade and the actual repo borrowing rate: the residual after financing costs is the trade’s return. Its example uses an implied rate of 15 basis points and repo funding at 12 basis points, leaving 2 basis points per dollar of financed bonds.

Leverage scales that residual against the investor’s posted capital. The example describes 30-to-1 leverage, turning the small per-bond return into a 60-basis-point return on the initial capital. This is not a guaranteed arbitrage: it assumes repo can be secured and locked, and identifies counterparty failure as a risk. The value and cost of collateral to the investor also matter, so the simplified calculation does not capture every financing, operational, or risk consideration.

Key ideas

• The trade earns the difference between the implied financing rate and the repo funding rate.
• Leverage magnifies the residual return relative to the investor’s posted capital.
• The example assumes borrowing can be secured and locked in.
• Counterparty failure and the opportunity cost of collateral affect the trade’s attractiveness.

Tags

# How does Repo enable zero cost leverage?


# How does Repo enable zero cost leverage?












There have been numerous headlines the past two years where we learn that quant funds are engaging in algorithmic basis trades (aka relative value trades) between Spot Treasuries and Treasury Futures, and that this is a rather large market ~$1 Trillion.

The returns on this arbitrage are of the order of a few bps. However, with Repo leverage, those returns are goosed up to make it worthwhile apparently.

If the Repo rate is of the order of the Fed Funds Rate, how can this be worthwhile? FFR currently is 9bps. If you borrow money via Repo at 9bps, how can you chase a return lower than that in basis trades?

## Answer by JoshK (score 2)

https://quant.stackexchange.com/a/69198

They mean the return after repo costs.

So for example, if you can buy the bond and sell the future for an implied rate of financing of 15bp and the market charges you 12bp, you will make 2bp on the trade with the only risk being counterparty failure. (assuming you can lock repo and borrow). Now you will have to put up collateral, so you have to figure out what's the value of that to you/your investors. You might get 30:1 leverage, so with \$100 you can buy/finance \$3,000 worth of bonds. Then you get a 60bp return. Not great, but better than nothing.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.