1. finlogIQ
Knowledge for financial IQ
STRICTLY PRIVATE AND CONFIDENTIAL
Chapter 6
Strategies for Futures Markets
August 2012
2. Chapter summary and outline
This chapter explains the strategies and techniques used by
different participants in the futures markets, including hedgers,
speculators / traders, arbitrageurs and portfolio managers.
Examples are provided to illustrate the various scenarios and
instruments used to achieve the different objectives of these
market participants.
Chapter outline:
• Participants in futures markets
• Speculating and trading
• Hedging and portfolio management
• Arbitraging
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3. Participants In Futures Markets
Types of Participants
• Speculators
• Hedgers
• Arbitrageurs
• Portfolio managers
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4. Speculators
• Three types of speculators
– Position traders
• hold positions over periods of days, weeks, or months for bigger movements
– Day traders
• the position is only held during the course of the day and covered before the
exchange is closed.
– Scalpers
• professional traders (often locals) who trade for minimal fluctuations.
• Their volume is normally high and they rarely hold overnight positions
• Speculators
– have certain expectations of the market and will take directional bets accordingly.
– Trade for institutions like banks, hedge funds or corporates
– By taking on the opposite side as the hedgers, speculators indirectly help to
improve liquidity in futures markets
• E.g. a money market trader expects interest rates to rise
– Borrow money from the market
• Once interest rates increase he can relend the fund at higher rates
– Sell interest rates futures contracts
• As interest rates rise, the futures price will decline and he can then cover his
short by buying back at a lower price
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5. Hedgers
• Normally seek to reduce or eliminate risks by doing the opposite trade in the
futures market.
– Offsetting trade in the futures market to reduce the losses suffered in the cash
market or vice versa.
• Where hedge vehicle used (futures contract) has underlying instrument
identical to the cash instrument to be hedged
– the hedging will be effective.
• If hedge vehicle used does not reflect the actual movement
– Basis risks involved
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6. Arbitrageurs
• Seek to make riskless profits from the disequilibrium between the cash and
futures markets
• Arbitrageurs will exploit the difference between the implied value and the
market value.
– Do not take directional bets on the market
– Take advantage of mispricings between two related markets
• Normally work for institutions
• Rely on computer systems to help them identify and capitalize on the
arbitrage opportunities.
– Disequilibrium can exist due to the mismatching of demand and supply in one
market.
– Such windows of opportunities generally close up very fast as the computers can
help to identify such opportunities fast and any disequilibrium is immediately
arbitraged away.
• Presence of arbitrageurs help to improve liquidity in the futures market
– Market is efficient and pricing relationship between the futures contract and its
underlying instrument is consistent.
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7. Portfolio Managers
• Investment professionals who manage a portfolio of investments, normally
of stocks or bonds.
• Identify investment that will optimize returns for investors
• Work for banks, hedge funds, and asset management companies
• Responsibilities of portfolio managers will include cashflow management,
currency hedging and stock picking.
• Use futures market for cash flow management, hedging as well as trading
– Lower transaction costs
– More liquid market
Example:
• A portfolio manager is long a basket of index stocks
• Believes prices will decline soon due to a decline in overseas stock markets
− Liquidate all the stocks and look to buy them back at lower prices
− Sell stock index futures to hedge his stock holdings
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8. Speculating and Trading
Types of Traders
• Profit from speculating in the price movements of futures contracts.
• Scalper trades for small gains
– establishing and liquidating a position quickly, usually within a small price range
and within the same day.
• A day trader is one who establishes and closes a security, option or futures
position during the same trading session.
• A position trader takes a long-term approach in maintaining positions in the
market and does not close out these positions until the profit objective or
loss limit is reached or until close to the delivery date.
• Margin in futures trading enables leverage
– Advantageous for the traders who want to trade their positions without having to
commit the full notional amount of the contract.
– Leverage can also cause huge losses because the size of the contract is much
larger, sometimes more than 10 times the original amount of margin that is
placed with the exchange.
• Trading decisions should be based on fundamental and technical analyses
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9. Speculating and Trading - 2
Outright Trades
• To express directional view of the market, ie buy or sell futures
Spread Trades
• Express a view of the relative price movements in the two contracts
– Buy one contract and sell another simultaneously
– Aims to profit from change in price differential between two contracts
• Types of spread trades
– Inter-delivery spread trades
• Spread is done on the same exchange, in the same commodity but for
different delivery months
• As known as intra-market or calendar spread
– Inter-market spread trades
• Same commodity, same delivery month but on different exchanges
– Inter-commodity spread trades
• Two different commodities having the same delivery month on the same
exchange
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10. Speculating and Trading - 3
Spread Trades (cont)
Examples:
• Calendar Spread
– If a trader sees a steepening in the yield curve, i.e. the far end rates will rise
more than short end rates, he buys the near contract and sells the far contract.
– He sells the near contract and buys the far contract if he thinks the yield curve is
flattening or inverting.
• Butterfly Spread
– A butterfly spread is bought if the nearby (wing) is expected to strengthen
relative to the distant spread
• Condor Spread
– This is a combination of 2 spreads, namely a bull spread and a bear spread, with
no common middle contract.
• TED Spread
– This is a spread between T-bill futures and Eurodollar futures and is normally
bought during flight-to-quality. It can also serve as an indicator of stock market
sentiment.
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11. Speculating and Trading - 4
Choosing Among Cash, Futures and Options
• Speculating and trading require fundamental and technical analyses
• Need to decide whether to use the cash instrument or its derivatives,
depending on
– Equivalent price of that instrument prevailing at the point of execution
– the total costs involved
– trading and credit limits
– other factors which may be peculiar to the person/institution looking to put on the
trade.
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12. Hedging and Portfolio Management
Identifying and Measuring Risk
• Objective of hedging is to reduce risk
– Adverse price move occurs, losses will be contained or profits will be protected
– If price moves favorabl,y the profit will be capped
• Hedging does not eliminate price risks, but converts price risks to basis risk
between the underlying instrument and the hedging instrument.
– Confines final price to a determinable range
– Hedging smoothens cashflow, simplifies financial planning, reduces working
capital requirement
– Allows more efficient product pricing and efficient inventory management.
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13. Hedging and Portfolio Management - 2
Developing an Effective Hedge Program
• Evaluate the risk exposure in assets and liabilities by group, by maturity or
profit centre.
• Set hedge objective in reduction of risks.
• Determine hedgeability using price correlation analysis and if necessary
cross hedges.
• Determine the hedge vehicle
– The hedge vehicle should have a high degree of correlation with the target
security.
– If the target security is different from the underlying security of the futures
contract, the yield relationship and the spread relationship between the two
securities must be studied and measured using regression analysis
– Typical hedging instruments are futures and options.
– In general, there are some limitations to the use of futures and exchange-traded
options for hedging
• Round number of contracts
• Margin maintenance
• Time horizon and expiry dates
• No exact hedge vehicle
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14. Hedging and Portfolio Management - 3
Developing an Effective Hedge Program (cont)
• Determine the rate or price that the user should lock in with the hedge
– Minimum variance hedges that are held to the futures delivery date provide an
example of the hedge that locks in the futures interest rate.
– If the hedge is to be lifted before delivery, the hedger can no longer be assured
of locking in a rate, spot or future due to the changes in basis i.e. the difference
between spot and futures rates.
• The value of the hedged position at time t is equal to the price of the
underlying security at time t plus the gain or loss on the futures contract.
Target Rate for hedge = Futures Rate + Target Rate Basis
• Target basis concept: hedge that is held till expiry locks in the futures rate.
However a hedge that is lifted before expiry merely substitutes price risk for
basis risk.
• A user can define the target rate, work backwards to find the hedge ratio
that gives the desired target. He has to take on greater risk than he would if
he chose a hedge ratio that equates the target price to the futures price
• Actual outcome of the hedge depends on whether the basis will decline
linearly over time as well as whether there is any great fluctuations in the
basis in the mean time
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15. Hedging and Portfolio Management - 4
Developing an Effective Hedge Program (cont)
• Hedges can be constructed for currently held positions or anticipated ones
• Hedges can be in place for a known or uncertain period of time.
• For a currently held cash position:
– Weak form cash hedge (Inventory hedge)
• Time horizon for which the portfolio will be held is indefinite
• Minimizes the price variance of the existing asset portfolio
– Strong form cash hedge (immunization)
• Time horizon for which the portfolio will be held is known
• Hedging goal is to minimize the variance in the expected total return on the
portfolio for a given investment period
• For an anticipated cash position:
– Weak form of anticipatory hedge
• to minimize the variance in an acquisition price (a rate of return for a
specified holding period) on asset flows to be received at an unknown date.
– Strong form of anticipatory hedge
• apply whenever a known amount of cash will be received at a certain date.
• to minimize the variance of the acquisition price for the cash securities or
one that most closely realizes market-forecasted price.
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16. Hedging and Portfolio Management - 6
Developing an Effective Hedge Program (cont)
Hedge Ratio
• Hedge ratio (h) defines the expected movement in value of the cash
instrument to be hedged given a particular movement in the value of the
futures contract, which is to serve as a hedge vehicle.
• The hedge ratio is defined as the ratio of options or futures to a spot
position (or vice versa) that achieves an objective such as minimizing or
eliminating risk.
• Equal dollar exposure in the futures contracts may not create the optimum
or delta-neutral hedge.
• Hedge ratio is the actual weighting of the hedge vehicle to the target
security.
– Equal dollar match, where h = -1
– Theoretical, where h = Change in security price / Change in futures price
= - ∆S/ ∆F
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17. Hedging and Portfolio Management - 7
Developing an Effective Hedge Program (cont)
Types of Hedges
• The nearby contract is preferred due to its liquidity and statistically high
correlation to the movement of the underlying instrument.
• When time horizon and expiry date mismatch, basis risk occurs.
• If hedging horizon extends beyond the expiration of the nearby contract, can
– use the nearby contract and rollover into a deferred one, OR
– use a deferred contract from the beginning.
– both options have basis risk at the time of termination of the hedge
• Where no exact futures contract for hedging an exposure
– the correlation between the hedge vehicle and the instrument to be hedged must
be properly studied to achieve the desired results.
• When the maturity date of the underlying instrument does not coincide with
the expiry dates of the hedge instrument, the two types of hedges:
– Interpolative hedge is used when time horizon straddles two expiry dates.
– Extrapolative hedge is used when time horizon stretches beyond the tenor of the
last traded contract.
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18. Hedging and Portfolio Management - 8
Developing an Effective Hedge Program (cont)
Types of Hedges (cont)
• STRIPS involve the use of successive futures contract months to match
delivery dates on the futures contracts with the rollover dates or tenor on a
cash loan.
• STACKS use the deferred contract months to match the rollover dates or
tenor on a cash loan.
Hedging of Long Term Interest Rate Risk
• Interest rates futures for hedging is straightforward
• Using bond futures to hedge a bond portfolio, there are a few complications.
− Conversion factor for deliverable bonds may require that the underlying security
be hedged by a number of futures contracts that is not a round number.
− Convergence is less perfect
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19. Hedging and Portfolio Management - 9
Developing an Effective Hedge Program (cont)
Hedging Equity Risks
• Two types of risks in equity portfolios
– Market/ systematic risks
– Specific/ non-market risks
• Stock index futures only hedge against market risks (ie market exposure)
– selling futures contracts when long in the stock market (short hedge)
– buying futures contracts when short in the stock market (long hedge)
• Beta
– the factor that is used to measure the portfolio risk or volatility compared to the
index.
– Decides whether the portfolio is more or less volatile than the index.
– Determined using regression analysis with regards to historical betas of the
respective stocks.
• Modified portfolio value (MPV)
– Value of actual portfolio multiplied by the weighted beta of stock portfolio.
– Weighted beta is the sum of product of the beta of each stock and percentage
share of the stock within the portfolio.
– This is used to determine the base hedge ratio
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20. Hedging and Portfolio Management - 10
Managing the Hedge
• Effectiveness of the hedge is the risk of a hedged position relative to an
unhedged position.
– If hedged position is determined to be 90% effective, over the long run the
hedged position will have only 10% of the risk of an unhedged position.
• Absolute risk of the hedge is expressed as a standard deviation.
– E.g. Hedged positions has a standard deviation of 10 basis point
– Assuming a normal distribution of hedging errors, the user will then obtain the
target rate plus or minus 10 basis points 67% of the time.
• Necessary to consider any hidden costs in hedging and to manage them
• Most hedges require very little active monitoring during their life.
– Changes in volatilities and yield spread relationships, for instance, may
necessitate changing the hedge ratio.
• When hedge is lifted, it is then evaluated to determine the sources of error
– to gain insights that can be used to the hedger’s advantage in subsequent
hedges.
– Normally, main sources of error are due to the projected value of the basis at the
lift date and the parameters estimated for cross hedges.
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21. Hedging and Portfolio Management - 11
Portfolio Management Techniques
• Determines investment mix and policy, matching investments to objectives,
asset allocation for individuals and institutions, and balancing risk versus
performance.
• Strengths, weaknesses, opportunities and threats of debt versus equity,
domestic versus international, growth versus safety
– Attempt to maximize return at a given appetite for risk
• Constantly readjust the balance of assets requires the ability to perform this
adjustment efficiently and cost effectively.
• Using futures to allocate assets is more effective and less expensive.
– Where the portfolio consists of different country exposure.
– Brokerage for futures transactions is cheaper.
– Transaction time is shorter
– Less impact on the market since the futures market is more liquid and the
transaction is less transparent.
– Less disruptive to the whole portfolio management process.
– Margining process, the amount of cash involved is smaller in sum and the
transactions can be tailored to the user’s cash flow need.
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22. Hedging and Portfolio Management - 12
Portfolio Management Techniques
• Futures are useful in loss control
– To unwind a bad position in the cash market may aggravate the losses due to
illiquidity or other reasons.
– To limit the losses, the user can hedge the risks via futures.
– When prices are more favorable, can unload the positions and uplift the futures
contracts at the same time.
• Where the accounting system permits, futures are also used to delay loss
realization.
– During financial reporting period, securities that are carried at cost can be
hedged against further losses using futures.
– After the reporting has completed, the losses are realised and the futures
contracts unwound
• Hedging equity risk
– market or systematic risk can be hedged with stock index options
– specific or non-market risk can be hedged with individual stock options
– The advantages here are flexibility in terms of timing and amount and
asymmetrical return profile.
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23. Arbitraging
• Arbitrageur is one who profits from the differences in price when the same,
or extremely similar, security, currency, or commodity is traded on two or
more markets.
– Profits by simultaneously purchasing and selling these securities to take
advantage of pricing differentials (spreads) created by market conditions.
– Aim to make risk-free profits by exploiting the disequilibrium between the futures
and cash markets.
– Use of computers is essential.
• Begins with the calculation of strips, followed by a comparison of market
prices of the underlying securities or related instruments
– Whenever there is a discrepancy between the strips and the market prices, there
is a possibility for arbitrage.
• The transaction costs associated with an arbitrage (brokerage, financing,
initial and variation margin) is necessary to ascertain if the returns are
justifiable, and whether there are any residual risks (like basis risks), are
needed.
• An investment/ trading strategy that exploits divergences between actual
and theoretical futures prices
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24. Arbitrage Using Interest Rate Futures
Arbitrage Between Cash and Futures
• Theoretically, futures are derivatives of the underlying cash markets
– arbitrage process would keep the prices in line in the two markets.
– The main constraints faced by many banks in this area are the balance sheet
constraints and return on assets.
– This is the reason why pockets of opportunities sometimes persist for a while.
• Example:
– Spot date = July 27
– July 27 till Sep 15 = 50 days
– Sep 15 till Dec 15 = 91 days
– Spot 50 days interest rates = 1.00% bid 1.0625% offer
– Spot 141 days interest rates = 1.25% bid 1.3125% offer
– Sep ED = 98.72
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25. Arbitrage Using Interest Rate Futures - 2
Arbitrage Between Cash and Futures (cont)
– Step 1 : Calculate the theoretical value for Sep ED.
• Lend 141 days at 1.25%
• Borrow 50 days at 1.0625%
– The discrepancy between the implied and market price of Sep ED show that
there is an arbitrage opportunity.
– Step 2 : Execute the arbitrage operation.
• Lend 141 days at 1.25%
• Borrow 50 days at 1.0625%
• Sell Sep ED at 98.72
– The arbitrage profit = (9872-9865) X 25 X Number of contracts
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26. Arbitrage Using Interest rate Futures - 3
Arbitrage Between Forward Rate Agreements (FRA) and Futures
• Forward rate agreement (FRA) is the OTC equivalent of futures.
– FRA can be tailored to the exact needs of the users in terms of the maturity date
and contract amount.
• Futures and FRA arbitrage risk-free only when the value dates correspond
– In cases where arbitraging is between futures and FRA with different value dates,
these will always be residual basis risks or fixing risks
• Using futures needs more careful liquidity management due to margin calls.
• A direct quotation will have a spread of 1 to 3 basis points spread while the
futures normally have a spread of 1 basis point.
– Price-maker an opportunity to arbitrage between futures and FRA
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27. Arbitrage Using Interest rate Futures - 4
Arbitrage Between Forward Rate Agreements (FRA) and Futures (cont)
• Minimize risks: care should be taken to ensure that there are no
technicalities (such as the financial year-end, share settlement date, etc.) or
important releases (such as unemployment figures, consumer price index,
etc.) taking place between the two dates.
• Disequilibrium in these markets may be due to institutional constraints
– Limits to deal in only one market and internal restrictions on hedging between
these instruments.
– Certain buying or selling activities in one market driving the prices in one
direction
– not hampered by restrictions would be able to capitalize on these arbitrage
opportunities.
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28. Arbitrage Using Interest rate Futures - 5
Arbitrage Between Futures and Interest rate Swaps (IRS)
• An interest rate swap is a transaction in which two parties agree to make
each other periodic payments calculated on the basis of specified interest
rates and a hypothetical (or notional) principal amount.
• Typically, the payment to be made by one party is calculated using a
floating rate of interest (such as LIBOR), while the payment to be made by
the other party is determined on the basis of a fixed rate of interest or a
different floating rate.
• The most popular IRS is that traded over the IMM (International Money
Market) dates with quarterly fixing of the floating rate.
• Arbitraging is possible whenever the market price differs from the strips
– Arbitrageurs can buy or sell the IRS and sell or buy the futures contracts that are
used to calculate the strips
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29. Arbitrage Using Options
• Take advantage of temporary discrepancies in the option pricing structures
• Premiums trade out-of-line with the price of the underlying instrument or
with the price of other options.
• Strategies used by option arbitrageurs
− Conversion (constant return to expiration date)
• A conversion consists of the sale of a call, and the purchase of a put, which
shares a common strike and expiration date with the call and the purchase
of the underlying instrument for which those options may be exercised.
• The combination of long put and long futures is equivalent to a synthetic long
call position.
• The synthetic long call when combined with a short call yields a fixed return
– Reversal (constant return to expiration date)
• Reversal represents the purchase of a call, the sale of a put which
shares a common strike and expiration fate with the call, and the sale of
the underlying instrument
• Purchase of a call and sale of the underlying instrument is equivalent to
a synthetic long put position
• Combined with short put position, will create a fixed return
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30. Arbitrage Using Options - 2
• Strategies used by option arbitrageurs (cont)
– Box spread
• Involves options exclusively (no need for underlying)
• Easier to execute by arbitrageurs who do not have ready access to the
underlying market
• involves the purchase and sale of a put and call at one strike price coupled
with the purchase and sale of a call and put at a different strike price.
• All four legs of the box share a common expiration date.
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