Hedging Repo Exposure in the Treasury Basis with One-Month SOFR Futures

A Treasury repurchase agreement (“repo”) is a key element of any Treasury cash/futures basis trade.  For example, being long a Treasury cash/futures basis position involves a long position in cheapest to deliver (or another note/bond eligible for delivery) Treasury note/bond and a DV01 weighted short position in the futures contract. The long basis typically involves financing ownership of a Treasury note or bond with funds borrowed in the Treasury repo market.   For this purpose, the borrowing typically occurs in the overnight bilateral repo market¹, with the bond or note posted as collateral for the loan. 

In the case of a long Treasury basis position, you would pay Treasury repo interest for as long as you hold the basis spread.  Conversely, in the case of a short Treasury basis position, you receive Treasury reverse repo interest for as long as you maintain the position.  In either case, unexpected shifts in repo rates can significantly impact its profitability.

Bilateral Treasury overnight repo data are a primary input to the Secured Overnight Financing Rate (“SOFR”) benchmark, accounting historically for around 55 percent of the trade activity on which the benchmark is based.²  For this reason, the SOFR benchmark provides a reasonable proxy for your Treasury overnight repo exposure, and CME One-Month SOFR futures offer a good tool for managing this risk.

Suppose that on Sep 28, 2018, you initiate a long cash/futures basis spread in “Classic” 10-Year Treasury Note (“ZN”) futures for Dec 2018 delivery (“ZNZ18”).  First, you identified the 2-7/8s of July 2025 to be the Treasury note that is cheapest-to-deliver for the ZNZ18 futures.  Assume you purchased $500 million face value of this note for a full price (price + accrued coupon interest) of $498,125,025.  On Oct 1, this purchase settles.  You intend to finance it by borrowing funds in repo until Dec 30, the day preceding the ZNZ18 contract’s last delivery day, Dec 31.

As a result, you expect to pay Treasury overnight repo from Oct 1 through Dec 30.   If you paid SOFR overnight for this time period, you would have paid an annualized rate of 2.241%, which represents the average daily SOFR for this 91 day period.  For your $500 M Treasury cash position, the cost from repo to finance your cash position would have been $2,821,754, if your overnight repo rate is identical to SOFR.

To hedge this overnight repo exposure, you would’ve sold similar amounts of October, November and December One-Month SOFR futures. Based upon the timing of your basis trade, your positions result in exposure to the repo rate for 91 days, from Oct 1 through Dec 30. Given the timing of the trade and size of the cash position, you need to sell 302 One-Month SOFR futures distributed across three contract months by number of days to hedge your overnight repo exposure: Oct 102, Nov 100, Dec 100. (302 contracts = ($ full price of note*0.0001*91/360)/$41.67 SR1 DV01)

Assume that you sold each of the Oct, Nov and Dec 2018 One-Month SOFR contracts at their settlement prices on Oct 1. You held the Oct and Nov 2018 One -Month SOFR contracts until their respective final settlement prices. You covered the short Dec 2018 position at the settlement price on Dec 31, the first available trading day following the conclusion of your repo exposure. Because of your futures hedges, you have locked in an average interest rate of 2.246%, nearly identical to the projected rate of 2.241% to finance your position. The average interest rate implied by the final settlement prices of the Oct, Nov and Dec contracts was 2.249%. 

Note that the lower rate to finance your position and profits from the hedges are attributable to a relatively higher SOFR of 3% on Dec 31 that was reflected in the SR1Z8 prices, but it was not included in the cost of financing the note.  Additionally, the short SR1Z8 position benefited from the market expecting SOFR on 12/31 be higher than it was. SR1Z8 settled at 97.6475 on 12/31, and it had a final settlement price of 97.657.

Please refer to the Exhibit 1 below for the trade details of the One-Month SOFR hedges.