Advanced Futures Strategies
Purpose: Discuss the use of more
complex futures strategies
in risk management
Overview
Synthetic counterparties for equity swaps
■  Stock index futures strategies
■  Synthetic counterparties for IIRM products
■  Short-term interest rate futures strategies
■  Intermediate-term and long-term interest rate
futures strategies
■
Stock index futures strategies
■  Asset
allocation
◆  Synthetic
counterparties for equity swaps
■  Alpha
capture
■  Dividend capture
■  Stock market timing with futures
Equity Asset Allocation Swap
Foreign Equity
Index Return* A
Investor
Underwriter
Foreign Equity
Index Return* B
*Equity index return includes dividends, paid quarterly or reinvested
Offsetting an Equity Asset
Allocation Swap
■  Underwriter
buys a package of futures on
Index A
◆  Maturities
match the payment dates in the swap
■  Underwriter
sells a package of futures on
Index B
◆  Maturities
match the payment dates in the swap
Equity Return Swap
Equity Index
Return*
Investor
Underwriter
Libor ± Spread
*Equity index return includes dividends, paid quarterly or reinvested
Offsetting an Equity Return
Swap
■  Underwriter
sells a package of LIBOR
futures
◆  Maturities
match the payment dates in the swap
■  Underwriter
buys a package of futures on
the Index
◆  Maturities
match the payment dates in the swap
Equity Call Swap
Equity Index Price
Appreciation*
Investor
Underwriter
Libor ± Spread
* No depreciation—settlement at maturity
Offsetting an Equity Call Swap
■  Underwriter
sells a package of LIBOR
futures
◆  Maturities
match the payment dates in the swap
■  Underwriter
buys a package of calls on the
index futures
◆  Maturities
match the payment dates in the swap
◆  Exercise price is as near as possible to the
current level of the index
Equity Asset Swap
Asset
Income Stream
Equity Index
Return*
Investor
Underwriter
Income Stream
* Equity index return includes dividends, paid quarterly or reinvested
Offsetting an Equity Asset
Swap
■
Underwriter buys a package of futures on the
Index
Maturities match the payment dates in the swap
◆  This leaves the income from the asset as the primary
source of remaining volatility
◆
■
Underwriter might sell a package of futures on
underlying assets that have strong correlation with
the asset involved in the swap
Maturities match the payment dates in the swap
◆  This would reduce the volatility, but not eliminate it
◆
Alpha Capture
How to take advantage of scarce
information
Measuring systematic risk with a
single-index model (the CAPM)
■
Regression analysis:
tool for measuring
interaction between
two variables related
by a linear function
y = α + βx + ε
R j − R f = α j + β j ( Rm − Rf ) + ε j
The meaning of Alpha
■
The meaning of α
Market pressure
Ri - Rf
A
B
Rm - Rf
Market pressure
Asset pricing models in general
■  Creating
surrogate portfolios
■  Using surrogate portfolios for arbitrage
◆  Goal:
buy something cheap and sell something
just like it for a higher price
◆  Goal: hedge against market movements as
protection while trading on scarce information
Betting Without Hedge
■
Suppose you sell GM short, based on scarce information
GM
Market
Take Position
Uncertain Future
Betting Without Hedge
■
Then market rises, carrying GM with it
GM
Uncertain Future
Market
Take Position
Betting Without Hedge
■
■
Then market rises, carrying GM with it
GM takes hit, but you still lose
GM takes hit
GM
Market
Take Position
Uncertain Future
Practice
■  Suppose
you know Texaco will announce
bad news
◆  Beta
is 0.95
◆  Describe a no-money-in, hedged position
designed to benefit from the information
More Practice
■  Suppose
you know GM will announce
bad news
◆  Beta
is 1.05
◆  Describe a no-money-in, hedged position
designed to benefit from the information
Market Timing
■
The basic idea of market timing is to get into
the market before it rises and get out before it
falls
◆
Translation:
✦  Positive
✦  Zero
■
beta in advance of rising market
beta in advance of falling market
Extreme market timing
Very large positive beta in advance of rising market
◆  Very large negative beta in advance of falling
market
◆
Basic Market Timing
■
So, if you hold a well diversified portfolio worth
$1,000,000 and you think you can predict ups
and downs of the market, do the following:
When you think the market is about to rise, hold the
stock without any position in the index futures, so
beta is 1
◆  When you think the market is about to fall, continue
to hold the stock selling $1,000,000* (∂f / ∂I) worth of
the index futures, so beta is 0
◆
✦  ∂f / ∂I = e(r-d)t
Somewhat Extreme Market
Timing
■
If you hold a well diversified portfolio worth
$1,000,000 and you think you can predict ups
and downs of the market, do the following:
When you think the market is about to rise, hold the
stock while buying $1,000,000 * (∂f / ∂I) worth of the
index futures, so beta is 2
◆  When you think the market is about to fall, continue
to hold the stock while selling $3,000,000 * (∂f / ∂I)
worth of the index futures, so beta is -2
◆
Dividend Capture
How to capture dividends without
bearing market risk
Dividend Capture (3% annual yield)
1,000 units
$1,000,000
Money
today
Spot 1000
R = 2%
Stocks
today
Dividend 1.5%
$ 1,010,022.22
Money at
day 182
$1,015,000
Future 1000
Stocks at
day 182
$ 15,000+1,000 units
Profit = $ 4,977.78
What is not balanced?
Synthetic Counterparties for
IRRM Products
Replicating sources of volatility
Caps
Illustration of a 7% Interest Rate Cap on LIBOR
Today
Later*
Client
Premium
Underwriter
Max[(LIBOR – 7%), 0]
Client
Underwriter
*Payments are made periodically (say, monthly or quarterly) over the life of the contract,
with rates appropriately adjusted for the number of periods per year
Offsetting a Cap
■  Underwriter
buys a package of call options
on LIBOR futures
◆  Option
expirations match the payment dates in
the cap
◆  Exercise price matches the amount of the cap
Floors
Illustration of a 3% Interest Rate Floor on LIBOR
Today
Later*
Client
Premium
Underwriter
Max[(3% – LIBOR), 0]
Client
Underwriter
*Payments are made periodically (say, monthly or quarterly) over the life of the contract,
with rates appropriately adjusted for the number of periods per year
Offsetting a Floor
■  Underwriter
buys a package of put options
on LIBOR futures
◆  Option
expirations match the payment dates in
the floor
◆  Exercise price matches the amount of the floor
Collars
Illustration of a 3,7 Collar on LIBOR
Today
Later*
Client
Client
Premium
Underwriter
Max[(LIBOR – 7%), 0]
+ Max[(3% – LIBOR), 0]
Underwriter
*Payments are made periodically (say, monthly or quarterly) over the life of the contract,
with rates appropriately adjusted for the number of periods per year
Offsetting a Collar
■  Underwriter
buys a package of call options
on LIBOR futures and a package of put
options on LIBOR futures
◆  Option
expirations match the payment dates in
the cap
◆  Exercise prices of the calls match the amount of
the cap
◆  Exercise prices the puts match the amount of
the floor
Short-term interest rate futures
strategies
■  T-bill
cash-and-carry/Implied repo arbitrage
■  Eurodollar arbitrage
Implied Repo Example
■  90-day
T-bills currently earn 7%
■  270-day T-bills currently earn 7.25%
■  Repo rate is 7.15% for bonds maturing on
day 270, for delivery on day 90
Implied Repo
$1,017,408.41
7.00%
$1,000,000
NY
today
NY
90 days
$1,018,537.72
7.15%
7.25%
NY
270 days
Profit = $1,129.31
$1,055,088.67
Eurodollar arbitrage
■  90-day
Eurodollar CDs currently earn 6%
■  270-day Eurodollar CDs currently earn
6.25%
■  Forward rate is 6.20% for CDs maturing on
day 270, for delivery on day 90
Eurodollar Arbitrage
$1,014,903.27
6.00%
$1,000,000
LON
today
$1,015,779.37
6.20%
6.25%
Profit = $876.11
LON
90 days
LON
270 days
$1,047,314.13
Intermediate-term and long-term
interest rate futures strategies
Delivery options
■  Implied repo/Cost-of-carry
■  Treasury bond spread/Implied repo arbitrage
■  Immunization (increasing or decreasing the
interest rate risk exposure)
■  Bond market timing
■
Treasury Bond Futures
■
These contracts are based on two assumptions:
Underlying bond has a 6% coupon rate
◆  Maturity or call date not earlier than 15 years from now
◆
■
The following major rules apply:
Delivery can take place on any business day during the
maturity month, with appropriate adjustment paid for
accrued interest
◆  A conversion factor can be used when delivering bonds
with a coupon rate different from 6%
◆
Example
■  Suppose
you are short the August 2016
contract
◆  You
decide to deliver bonds with coupon of 8%
and maturity in August 2032 (16 years)
◆  Conversion Factor (CF) is the price of a bond
with face value of $1, coupon and maturity
equal to the deliverable, and yield of 6%
◆  So, the CF in this case is 1.2039
Delivery Options
■  Because
of the flexibility regarding
delivery, some delivery options arise
◆  Wild
Card Option
◆  Quality Option
◆  End-of-Month Option
◆  Timing Option
Wild Card Option
■  Arises
when the futures market closes
before the bond market
■  If bond price moves favorably when the
futures market is closed, the holder of a
short position might choose to purchase
bonds for delivery
■  With the futures market closed, the futures
price cannot adjust
Quality Option
■  Arises
from the ability of a short trader to
pick the most favorably priced deliverable
■  May arise from flaws in the formula for
calculating the CF
■  May arise from imbalances in the bond
market
End-of-Month Option
■  Arises
from the opportunity to delay deliver
until the last business day of the month
Timing Option
Arises from the opportunity to capture a coupon
payment due during the delivery month
■  Early delivery may be advantageous to the shortholder is the cost of financing exceeds the coupon
■  Late delivery may be advantageous to the shortholder is the coupon exceeds the cost of financing
■
Market Timing for Equity
■
The basic idea of market timing is to get into
the market before it rises and get out before it
falls
◆
Translation:
✦  Positive
✦  Zero
■
beta in advance of rising market
beta in advance of falling market
Extreme market timing
Very large positive beta in advance of rising market
◆  Very large negative beta in advance of falling
market
◆
Basic Equity Market Timing
■
So, if you hold a well diversified portfolio worth
$1,000,000 and you think you can predict ups
and downs of the market, do the following:
When you think the market is about to rise, hold the
stock without any position in the index futures, so
beta is 1
◆  When you think the market is about to fall, continue
to hold the stock selling $1,000,000 worth of index
futures, so beta is 0
◆
Somewhat Extreme Equity
Market Timing
■
If you hold a well diversified portfolio worth
$1,000,000 and you think you can predict ups
and downs of the market, do the following:
When you think the market is about to rise, hold the
stock while buying $1,000,000 worth of the index
futures, so beta is 2
◆  When you think the market is about to fall, continue
to hold the stock while selling $3,000,000 worth of
the index futures, so beta is -2
◆
Market Timing for Bonds
■
The basic idea of market timing is to get into the
market before it rises and get out before it falls
◆
Translation:
✦
✦
■
Long duration in advance of falling interest rates
Short duration in advance of rising interest rates
Extreme market timing
◆
◆
Very long duration in advance of falling interest rates
Very long negative duration in advance of rising interest rates
Basic Bond Market Timing
■
So, if you hold a portfolio of bonds worth
$1,000,000 (duration 15 years) and you think
you can predict ups and downs of interest rates,
do the following:
When you think the rate is about to fall, hold the
portfolio without any position in the bond futures, so
duration is 15 years
◆  When you think the rate is about to rise, continue to
hold the portfolio while selling $1,000,000 worth of
the bond futures, so duration is near 0
◆
Immunization
■
Immunization might be appropriate for a bank
with the following
Asset portfolio has average duration of 10 years
◆  Liability portfolio has average duration of 1 year
◆
■
Immunization would use the same techniques
as market timing strategies in order to
Shorten the duration of the asset portfolio
◆  Adjust the duration of the liability portfolio so they
are both nearly the same
◆