Back to Basis: Recent Evidence on Arbitrage Strategies and Interest Rate Derivatives

Abstract

We examine near-arbitrage strategies in the market for interest rate derivatives. Using futures and forward rate agreements, we construct replication portfolios that match cash flows of vanilla interest rate swaps. Standard arbitrage theory suggests that the difference, or basis, between swap rates implied from futures and forward rate agreements and the market swap rate should be close to zero. Despite being some of the largest and most liquid markets in the world, we find mispricings using both futures and forward rate agreements.