Many investors in equity index products use the official closing index level as their benchmark for trading, but when trading futures, how could you execute against the closing index price? The basis trade at index close, or BTIC, solves this problem by allowing market participants to trade futures at a fixed spread to the closing underlying index level.
A buyer and seller agree to trade futures contracts, but instead of agreeing to a specific price they agree to a spread or basis to be added to that day’s closing index level to determine the futures price. This basis is agreed upon before that day’s index level is known. The value of the basis depends on the all-in financing rate, dividends, and the time left to contract maturity. The value can either be negative or positive.
Once the official closing index level is published, the actual futures are transacted at a price equal to the closing index level, plus the agreed upon spread.
A fund manager benchmarked to the Nikkei Index receives an inflow of $50 million to be put to work at that day’s closing index level. At the current index level, of 21750, he calculates that the fair spread between the Nikkei 225 futures and the cash index is -7.25.
Seeing that the Nikkei 225 futures multiplier is ¥500 and applying a U.S. dollar to Japanese Yen exchange rate of 112.85, he submits a bid to buy 10 Nikkei 225 futures, at that spread versus the afternoon’s closing index level.
Nikkei 225 (21750) x ¥500 = ¥10.875 M
¥10.875 M / 112.85 (exchange rate) = $96,367
50 M USD /96,367 USD = 519 contracts
At the same time a trader on the equity finance desk of a large investment bank concludes he could save money by replacing his short physical stock basket position in the Nikkei 225 constituents with futures. He calculates that he needs to sell those futures at a basis of -7.25 or higher. He sees the fund managers bid and hits it. The trade is executed.
Having sold the futures, the equity finance desk then enters a portfolio trade to buy a $50 million index replicating stock basket at the closing market price to reduce his short stock position as planned. The BTIC trade is complete.
Shortly after 3:00 p.m. Tokyo time, the official Nikkei 225 Index close of 21749.78 is published. The trade is now settled.
The fund manager buys 519 Nikkei 225 futures at a price of 21742.53, which is a -7.25 basis to the closing index level, and the equity finance trader sells them at the same price.
We’ve seen how index fund managers can use BTIC, and how it allows equity finance, index arbitrage and stock loan traders to optimize their holdings between futures and physical stock.
A wide range of other market participants also use BTIC including equity swap traders who use BTIC when hedging market-on-close trade exposures and index option traders who use BTIC to take advantage of the surging volume at the cash close to adjust futures delta hedges with minimal impact.
The BTIC orderbook for Nikkei 225 index is open more than 13 hours a day, allowing real time price discovery in the futures market, as investors around the globe submit orders against the next index close.