In this chapter we look in more detail at some fundamentals behind the basis, including the factors that drive its behaviour, and we also consider implications of the short future's delivery option. There is also, in Appendix C at the back of this book, recent delivery history for the London International Financial Futures Exchange (LIFFE) long gilt future, for illustrative purposes and to observe delivery patterns.
Having discussed (in Chapter 2) the theoretical foundation behind futures prices, it is nevertheless the case that they move out of sync with the no-arbitrage price and present arbitrage trading opportunities. A review of the US Treasury or the gilt bond basis relative to the bond carry would show that the basis has frequently been greater than the carry, and this would indicate mis-pricing in the futures contracts.1 The anomalies in pricing are due to a number of factors, the principal one of which is that the short future has the option of delivery. That is, the short picks which bond to deliver from the basket, and the time at which it is delivered. The long future simply accepts the bond that is delivered. It is this inequality that is the option element of the contract.
We will take a look at this, but first let's consider the principle behind no-arbitrage delivery.
At the expiration of a futures contract, after the exchange delivery settlement price has been ...