A 30 stock basket is 6 basis points cheap to its index future. Buying the basket costs 2 basis points in half spreads, selling the future costs 0.25 basis points, and unwinding into the expiry auction costs about 1.5 basis points. On $100m, what is the net edge in dollars and what risk is left?

A 30 stock basket is 6 basis points cheap to its index future. Buying the basket costs 2 basis points in half spreads, selling the future costs 0.25 basis points, and unwinding into the expiry auction costs about 1.5 basis points. On $100m, what is the net edge in dollars and what risk is left?

Approach: Net the entry and exit costs against the gross basis, convert the remainder to dollars, then ask what exposure survives once the price risk has been matched off.

$22,500. The gross basis is 6 basis points, entry costs 2 + 0.25 = 2.25 basis points and the exit into the expiry auction costs 1.5, so the net edge is 6 - 2.25 - 1.5, which is 2.25 basis points, which on $100m is $22,500. Price risk is matched between the basket and the future, so what remains sits in the dividends assumed between now and expiry, corporate actions that change basket weights, the financing rate over the holding period, and the auction print itself, which can differ from the theoretical close. Index arbitrage at 2.25 basis points is really a carry trade on those four items, and one dividend cut worth 10 basis points of index value wipes out four such trades.

Follow-up: Three of the thirty names cannot be shorted. How do you run the trade and what tracking error does the substitution add?

Key concepts: index arbitrage, basis, execution cost, dividend risk.