basis risk vs spread risk

[rookie77]

is there a difference between the two? i've read some threads and searched online and am still not sure. could someone please clarify for me (maybe with an example) what is basis risk?

thanks

 

[Martinghoul]

Depends on the context... What's the asset class?

 

[rookie77]

swaps and treasuries?

 

[Martinghoul]

In fixed income mkts:
basis - spread between cash bonds and bond futures (occasionally, people also talk about basis in the context of bond - CDS spread)
spread - aka swapspread, aka asset swap, aka TED; spread between a treasury instrument (cash bond or bond future) and a LIBOR instrument (swap or Eurodollar future)

Make sense?

 

[rookie77]

1. Do you only have basis risk when hedging? For ex. you are long bond futures and short cash bonds then you have basis risk? And if you are long both bond futures and cash bonds, there is no basis risk?

2. If I am long the 10 yr treasury, do I have spread risk? My guess is no since it seems that that I would only have interest rate risk with respect to how the 10 yr tenor on treasury yield curve moves. How the swap curve moves would make no difference. Is that correct?

Thanks again, you're always helpful as usual!

 

[Martinghoul]

1. You have basis risk when you're long one type of instrument and short the other. If you're long both, it doesn't make sense to talk about basis.

2. Well, yes and no. Your outright position doesn't have any spread risk. However, you need to keep in mind how you fund yourself.

 

[rookie77]

what do you mean by funding yourself with respect to having an outright long position in 10 yr Treasuries?

 

[Martinghoul]

Well, whatever positions you might have, whether long or short, you need working capital, right? For margins, etc... That capital has a cost (either explicit, if you're borrowing it, or an implicit opportunity cost, if it's your real money). Depending on the rate that determines your cost of funding you may, indirectly, be long or short spreads. See what I mean?

 

[rookie77]

so if i wanted to fund a long position in corp bonds (and not use my own money), I would have to borrow the capital through some sort of loan? And the borrowing rate is directly correlated with the swap rate and that is why i, indirectly, have spread risk?

 

[Martinghoul]

so if i wanted to fund a long position in corp bonds (and not use my own money), I would have to borrow the capital through some sort of loan? And the borrowing rate is directly correlated with the swap rate and that is why i, indirectly, have spread risk?

Yeah, spot on... Whether you're long or short bonds, you may be implicitly long or short spreads.

 

[rookie77]

thanks Martinghoul!