The 2nd edition of The Futures Bond Basis, is an updated and revised version of Professor Moorad Choudhry's succinct but in-depth look at the government bond futures contract basis. It includes essential background on contract specifications and the theory of the basis. It also covers the concept of the cheapest to deliver; price and delivery data for a sample of gilt contracts; the drivers of the basis and its dynamics; the mechanics of basis trading; a detailed explanation of gross and net basis, and an explanation of the implied repo rate. The book uses examples from the UK gilt market, although the basic principles are applicable in any bond futures market. Basis trading is an important part of the government bond markets. In this book we review the essential elements of this type of trading. Written by a former government bond market maker and proprietary bond trader, the book features: Basic concepts of forward pricing - The determinants of the basis - Repo financing - Hedging using bond futures - Trading the basis and an introduction to trading strategy - The concept of the cheapest-to-deliver bond - The net basis and the implied repo rate The book is illustrated with in-depth practical examples and written in an accessible style. It will be of vital use to anyone with an interest or involvement in the government bond futures market. Basis trading is an important part of the government bond markets. In this book we review the essential elements of this type of trading. Written by a former government bond market maker and proprietary bond trader, the book features: Basic concepts of forward pricing - The determinants of the basis - Repo financing - Hedging using bond futures - Trading the basis and an introduction to trading strategy - The concept of the cheapest-to-deliver bond - The net basis and the implied repo rate The book is illustrated with in-depth practical examples and written in an accessible style. It will be of vital use to anyone with an interest or involvement in the government bond futures market. Dr Moorad Choudhry is Head of Treasury at KBC Financial Products in London. He is a Visiting Professor at the Department of Economics, London Metropolitan University, a Visiting Research Fellow at the ICMA Centre, University of Reading, a Senior Fellow at the Department of Mathematical Trading and Finance, Cass Business School, and a Fellow of the Securities and Investment Institute. The Futures Bond Basis By Moorad Choudhry John Wiley & Sons Copyright © 2006 Moorad Choudhry All right reserved. ISBN: 978-0-470-02589-5 Chapter One BOND FUTURES CONTRACTS A widely used trading and risk management instrument in the bond markets is the government bond futures contract. This is an exchange-traded standardised contract that fixes the price today at which a specified quantity and quality of a bond will be delivered at a date during the expiry month of the futures contract. Unlike short-term interest rate futures, which only require cash settlement, bond futures require the actual physical delivery of a bond when they are settled. They are in this respect more akin to commodity futures contracts, which are also (in theory) physically settled. In this first chapter we review bond futures contracts and their use for trading and hedging purposes. 1.1 INTRODUCTION A futures contract is an agreement between two counterparties that fixes the terms of an exchange that will take place between them at some future date. They are standardised agreements as opposed to 'over-the-counter' or OTC ones, as they are traded on an exchange, so they are also referred to as exchange-traded futures . In the UK financial futures are traded on LIFFE , the London International Financial Futures Exchange which opened in 1982. LIFFE is the biggest financial futures exchange in Europe in terms of volume of contracts traded. There are four classes of contract traded on LIFFE: short-term interest rate contracts, long-term interest rate contracts (bond futures), currency contracts and stock index contracts. Bond futures contracts, which are an important part of the bond markets, are used for hedging and speculative purposes. Most futures contracts on exchanges around the world trade at 3-month maturity intervals, with maturity dates fixed at March, June, September and December each year. This includes the contracts traded on LIFFE. Therefore, at pre-set times during the year a contract for each of these months will expire , and a final settlement price is determined for it. The further out one goes the less liquid the trading is in that contract. It is normal to see liquid trading only in the front month contract (the current contract, so that if we are trading in April 2005 the front month is the June 2005 future), and possibly one or two of the next contracts, for most bond futures contracts. The liquidity of contracts diminishes the further one trades out in the maturity range.