Expressing Market Views: Spot, Forward and Swap Trading Strategies
Chapter 4 is where theory starts doing real work. The authors take the relative value triangle from earlier chapters and actually build trades around it. This is the part where you stop nodding along and start seeing how the pieces fit together.
The chapter covers strategies along each side of the triangle: spot-forward, spot-swap, forward-swap, and options. This post handles the first two. The options part gets its own post because there is a lot to unpack there.
The Spot-Forward Relationship: Bond Basis Trading
Let’s start with the bond futures market. Bond futures are interesting because there is no actual bond that matches the futures contract. Take the Bund future on Eurex. It references a notional bond with a 6% coupon maturing in 8.5 to 10.5 years. That bond does not exist. Instead, the exchange specifies a basket of real bonds that the seller can choose to deliver.
This is where the cheapest to deliver (CTD) concept comes in. The seller of a bond future will pick whichever bond is cheapest to buy and deliver. That bond drives the futures price. Simple enough in concept, but the details get tricky.
Finding the CTD
There are three common ways to figure out which bond is the CTD:
- Lowest converted forward price. Calculate each bond’s forward price to the delivery date, divide by its conversion factor. The lowest one wins.
- Highest implied repo rate. The implied repo rate is the return you would earn from buying a bond and selling the future. The bond with the highest implied repo relative to its actual repo cost is the CTD.
- Lowest net basis. The net basis captures the profit or loss from a cash-and-carry trade after accounting for carry costs.
Usually all three methods point to the same bond. The conversion factor system tries to make all deliverable bonds equally attractive, but it does not actually work. When yields are below the notional coupon, the shortest maturity bond with the lowest price sensitivity (DV01) tends to be cheapest. When yields are above the notional coupon, the opposite happens. The long duration bond becomes CTD.
What Is the Basis, Really
The gross basis is just the difference between the cash bond price and the futures price adjusted by the conversion factor. It captures the carry on the position at a single point in time.
The net basis goes further. It takes the gross basis and subtracts the actual cost of carrying the position to futures maturity. If you buy a bond, sell the future, and hold to delivery, the net basis tells you whether you make or lose money. Positive net basis means a loss on that strategy. Negative net basis (rare) means a profit.
Here is the confusing part. The net basis also represents the value of the delivery option embedded in the futures contract. The seller of the future gets to choose which bond to deliver. That choice has value. The net basis is the price the buyer pays for being short that option.
Actually Trading the Basis
Basis trading means taking offsetting positions in the cash bond and the future. Long the basis means you buy the bond and sell the future. Short the basis is the reverse.
What matters is the relative movement, not the absolute levels. If the basis widens, the long basis trader profits. If it contracts, the short basis trader profits.
What drives the basis? Mostly the shape of the yield curve. A steepening curve tends to widen the basis. A flattening curve tends to narrow it. Repo rates matter too. If the CTD goes “on special” in the repo market, the basis expands. And the basis naturally converges to zero as you approach delivery.
The authors walk through a detailed example of a US Treasury basis trade. A trader buys $100 million of the CTD, sells 936 futures (not 1,000, because you need to adjust for the conversion factor to stay market neutral). The yield curve steepens as expected, the gross basis widens from about 0.58 to 0.83, and the trader profits roughly $430K.
One thing worth noting: a long basis position is actually net long convexity. The futures contract has negative convexity because it tracks the CTD, which can switch. The cash bond has positive convexity. So the basis trader gets a profile that looks a bit like a long straddle. The cost is the net basis itself, which decays to zero at delivery.
The Spot-Swap Relationship: Trading Swap Spreads
Now let’s move along the triangle to the spot-swap relationship. This is about the connection between sovereign bonds and interest rate swaps.
Why Swap Spreads Exist
Swap rates are usually quoted as a government benchmark yield plus a spread. That spread exists because of credit differences between the banking sector (which is the counterparty risk behind LIBOR) and the government sector.
But credit is not the only driver. The swap spread moves around for several reasons:
- Government bond supply. More issuance pushes yields up and spreads down.
- Banking sector health. If banks look shaky, people buy government bonds and LIBOR rises. Spreads widen.
- Shape of the swap curve. A steep curve incentivizes receiving fixed, pushing swap rates down and spreads lower.
- Direction of rates. Rising rate environments tend to see wider spreads. Falling rates see narrower spreads.
Trading Swap Spreads in Practice
The authors give a clean example. In November 2009, the 5-year USD swap spread was around 40 basis points. A trader expected it to fall back to its short-term range.
The trade: receive fixed on a 5-year swap and short US Treasuries. The position is DV01-neutral so that parallel rate moves do not affect it. When the swap spread compresses from 40.4 to 31.1 basis points two weeks later, the trader closes out for a profit of about $34,500 on a $10 million notional.
It is a straightforward trade in concept. You isolate the spread between two related instruments and bet on its direction. But you need to think about the financing. The short Treasury position requires the repo market. The carry matters.
The Strange Case of Negative Swap Spreads
Here is something the textbooks from a decade earlier would have called impossible. In 2008-2010, the 30-year USD swap spread turned negative. That means the government was paying more to borrow for 30 years than the banks implied by the swap market.
Does that mean banks are safer than the US government? Not exactly. A swap rate reflects the risk of a LIBOR panel bank defaulting in the next three months, rolled forward repeatedly. A 30-year government bond carries sovereign risk for the full 30 years. A negative swap spread just means the market thinks banks can survive the next few months better than the government can manage the next three decades.
The negative spread persisted because of a perfect storm: massive government borrowing, corporate hedging flows, the Lehman collapse, and counterparty concerns that prevented the usual arbitrageurs from stepping in. In theory the dislocation should have been short-lived. In practice, it lasted years.
My Take
What strikes me about this chapter is how practical it is. The basis trading section alone could be a short course. Most people learn about bond futures and think they understand them. Then you hit the conversion factor, the delivery option, the net basis, and you realize there are layers on layers.
The key insight for me is that every trade has multiple dimensions. A basis trade is not just about carry. It is also an options position. A swap spread trade is not just about credit. It is about supply, demand, curve shape, and the direction of rates. You need to think in multiple dimensions or you will miss what is actually driving your P&L.
The authors themselves note that bond futures is one of the hardest subjects for people to grasp. I believe it. But once you do, you see how the cash and derivatives markets are deeply connected. That connection is where relative value opportunities live.