Expanding Trading Horizons With CME Group s E-mini S&P 500 Futures

Transcription

1 Expanding Trading Horizons With CME Group s E-mini S&P 500 Futures Deep, liquid U.S. market offers opportunities for Korean traders By Lawrence Morgan March 4, 2013 The Korea Exchange has a great deal to be proud of in its enormously successful KOSPI 200 Stock Index futures contract. This contract, launched in 1996, has attracted not only Korean traders, investors and fund managers, but also intense interest from foreign investment managers. As investors recognize the world over, however, it is unnecessarily limiting to confine oneself to one s own domestic market. As good as the KOSPI 200 contract is, as deep and liquid as it is and as much as it provides traders and investors with excellent opportunities due to its trends and volatility, Korean participants who have confined themselves to KOSPI 200 can improve and expand their index futures universe by including other stock index futures contracts in their portfolios. In particular the CME Group s E-mini S&P 500 Index futures contract (and its parent, the big S&P 500 futures contract) would be an especially good addition to those portfolios. Consider the attractions of the E-mini S&P contract: It represents the standard measure of the U.S. equity market. Not only investment professionals but also academic researchers use the S&P 500 index as the market when looking at the daily movement of American equities, as well as long-term returns to equity investments. The E-mini S&P 500 contract is a very deep, liquid contract which trades almost around-the-clock. Even during normal Korean market hours nighttime in America bid/ask spreads are narrow (typically the minimum tick value of 0.25 price points, worth $12.50) and the quantity or size on those bids and offers is very substantial, usually between 75 and 150 contracts, which is comparable to the size on bid and offer for the KOSPI 200 futures (and the size is much larger during the American trading day). Price volatility, for instance in terms of daily high-low price ranges, is appreciable usually about 19 points, worth $950 (approximately 1 million Korean won) per contract. This characteristic also compares very favorably with the KOSPI futures, whose daily range is about 2 points, also 1 million won. The E-mini S&P 500 contact is accessible to traders through the CME Group s Globex trading platform and through proprietary front-end trading systems provided by Korean futures brokerage firms. This system is fast, reliable, and adaptable to the varied needs of traders. Naturally, the largest price movements in E-mini S&P 500 futures normally occur during U.S. trading hours, since it is an index of U.S. shares whose prices respond primarily to news of the American economy, earnings and sales reports of American corporations, and American government and central bank developments. However, as all traders know, markets are global and prices react to events and information from every corner of the planet at every hour of the day and night. 1

2 For instance, E-mini S&P 500 futures prices are very sensitive to economic reports from China, the world s second largest economy, just as the KOSPI 200 Index is. These and other East Asian developments, occurring during the East Asian trading day, are carefully monitored and affect American shares and stock indexes just as they affect Asian shares and indexes. Additionally, even American corporations included in the S&P 500 index are themselves increasingly involved in Asian markets for resources and consumers so that a personal consumption report from Korea, China, or Japan can have important implications for American firms striving to sell into those markets. Furthermore, many American corporate earnings reports appear shortly after the close of the U.S. markets so that Asian traders (and the night shift of American traders) have an early opportunity to respond to such information even in American indexes such as the E-mini S&P. All of this market liquidity, efficient execution engines, good movement in prices, and price sensitivity during Korean trading hours makes the E-mini S&P 500 futures contract attractive for Korean market participants to include in their portfolios of trading instruments. This conclusion applies to outright trading and to trading on a relative value basis against KOSPI 200 futures, both for longer-term positions and short-term or intra-day trading. Institutional Investors For such institutional users of the E-Mini S&P 500 futures contract, however, various forms of relative-value (RV) trading and more elaborate portfolio constructions which combine and balance exposures in Korean and American equity index futures to more precisely express an investor s view of the two markets relative opportunities and risks are available. What follows are descriptions of a few such combinations that institutional investors may consider. (Keep in mind that none of these are recommendations of particular positions. Rather they are illustrations of how positions in the markets might be combined in various environments and what the results might be.) (a) If KOSPI 200 futures rise and S&P 500 futures decline (or the reverse) This is an obvious possibility, and in the last few years the directions of the two indexes have sometimes diverged. They normally move in the same overall direction, as Chart 1 indicates (the line representing the KOSPI 200 is actually 10 times the index to make comparison clearer). In fact the correlation between the two futures contracts over the last five years ( ) has been 0.80, or 80% a pretty high correlation but there have been many short periods when they diverge. And even this correlation is not consistent over the years: in 2008 and 2009 it was about 95%, but in 2010 only 72%, then 89% in 2011, and in 2012 the correlation between the two indexes declined to 52%. All of the points made above are as valid for fund managers and other institutional investors as for individual traders. Tightness of bid/ask spreads, market depth and liquidity, execution efficiency, and price volatility all are attractions for such professional participants who take outright directional market positions. Among these, market depth is probably most important since institutions are likely to enter and exit large positions and want large transactions to be executed expeditiously. For them the average contracts on bid and offer during Korean hours represents about $5 million to $11 million in notional value (about 5.3 billion to 11.7 billion won), and of course the depth is even greater during American trading hours. Index /2/2008 4/2/2008 7/2/2008 CHART 1 E-mini S&P 500 and KOSPI 200 Futures (rolling leading contract month) (KOSPI is 10 x the index for clarity) 10/2/2008 1/2/2009 4/2/2009 7/2/ /2/2009 1/2/2010 4/2/2010 7/2/ /2/2010 1/2/2011 4/2/2011 7/2/ /2/2011 1/2/2012 4/2/2012 Date E-Mini S&P KO SPI 200 7/2/ /2/2012 2

3 (b) If the indexes both rise This situation is much more common. Although there has been a generally strong correlation among all stock indexes in recent years this has gotten a great deal of attention since the beginning of the global financial crisis in 2007 the movements in KOSPI and S&P have often differed noticeably. One can see this from the ratio of the indexes, shown in Chart 2 for During 2012, for instance, the ratio of the E-mini S&P 500 futures to KOSPI 200 futures fluctuated between about 5.0 and 5.8, which amounts to a change of 14% to 16% of the level of the ratio. Not only that, this ratio did not move only in one direction but rose from roughly 5.0 early in 2012 to 5.8 in the autumn, then declined again to 5.2 by the end of the year. In fact, there were appreciable shorter-term movements within the year (e.g. from 5.75 in July to 5.4 in August, then back to 5.8 in September). There were similar fluctuations in this ratio in all these years, especially in The level of the ratio has also varied quite a bit from year to year. The opportunity for this approach is a standard feature of the markets; when an investor anticipates such a move it presents a noteworthy opportunity. When an investor anticipates such a change in the index ratio, it must be kept in mind that the level and notional values of the futures contracts differ quite a bit (the notional value of the KOSPI 200 futures is 500,000 won times the index; for the E-mini S&P 500 futures it is $50 times the index see the comparison table at the end of this note); this means the positions must be balanced financially, in the same way that hedgers balance the value of positions in commodity markets. Using levels for the end of 2012, one would have faced this comparison: KOSPI 200 E-mini S&P500 Ratio Index level Index value* (KRW) 133,050,000 75,490, Index value* (USD) 125,136 71, * Using the 12/31/2012 USD/KRW level Accordingly, such a ratio position should balance these values for every 100 contracts of KOSPI 200 the position would require E-mini S&P 500 contracts (176 contracts, for practical purposes). If the index ratio does not change, even if the levels do change, this position would be balanced no profit, no loss CHART 2 Ratio: E-mini S&P 500/KOSPI Suppose the strategy is to buy KOSPI 200 futures and sell E-mini S&P 500 futures, expecting both to rise but KOSPI futures to rise more; then both rise 10%, putting the KOSPI 200 futures at and the E-mini S&P 500 at 1,562. This movement produces a profit in the KOSPI 200 futures position and a loss in the E-mini S&P 500 futures position, almost exactly cancelling once another. If KOSPI rises more than the S&P as this hypothetical investor expects the profit in the KOSPI 200 futures exceeds the loss in the E-mini S&P 500 to produce a net profit. The values will change in this way: 4.00 J F M A M J J A S O N D

4 100 KOSPI 200 futures 176 E-mini S&P 500 futures CASE 1: both indexes rise 10% INITIAL Index Contract value (KRW) 133,050,000 75,490,040 Position value (KRW) 13,305,000,000 13,286,247,040 FINAL Index Contract value (KRW) 146,355,000 83,039,044 Position value (KRW) 14,635,500,000 14,614,871,744 PROFIT/LOSS +1,330,500,000-1,328,624,744 Net +1,875,256 CASE 2: KOSPI 200 rise 12%, E-mini S&P 500 rises 10% INITIAL Index Contract value (KRW) 133,050,000 75,490,040 Position value (KRW) 13,305,000,000 13,286,247,040 FINAL Index Contract value (KRW) 149,015,000 83,039,044 Position value (KRW) 14,901,500,000 14,614,871,744 PROFIT/LOSS +1,596,500,000-1,328,624,744 Net +267,875,255 Additionally, investors following such a strategy are also facing a currency risk, whether the home currency is the won or the dollar. These illustrative calculations are made based on an unchanged exchange rate of A currency hedge may be advisable, even necessary, using non-deliverable forwards or USD/KRW futures contracts at CME or KRX. (c) Expand the Efficient Frontier Many institutional investment managers are not concerned with forecasting absolute market direction or even relative value but are very attentive to optimizing the balance of risk and reward along the most inclusive efficient frontier of investment portfolios. Typically, the more assets or asset classes included in an investment universe the better the possible combinations higher expected returns, lower expected volatility, or both. That seems to be the case when one adds E-mini S&P 500 futures to the mix available to Korean investors. The chart below (Chart 7) is very approximate, but it illustrates this principle. The pink points represent portfolios combining only the KOSPI 200 futures and Korean government bonds, while the blue points show portfolios that also include E-mini S&P 500 futures. The broader universe expands the efficient frontier northwest, bringing in points that involve a more advantageous balance of risk and reward. It must be emphasized that this chart is very approximate and by no means includes all the asset classes available. It is intended only to represent the point that a Korean institutional investor can usefully expand and improve the efficient frontier by including the very deep E-mini S&P 500 contract among the instruments in the investment universe and thereby provide a greater opportunity for the investor to realize the strategy that is optimal for the relevant portfolios 4

5 Portfolio Expec ted Return C HA RT 3 Effic ie nt Frontie r Exc luding (pink) a nd Inc luding (blue )Em ini S&P 500 futures Risk (Portfolio Sta nda rd Devia tion) Conclusion CME Group s E-mini S&P 500 futures contract provides a liquid, deep, almost 24-hour market to both individual traders and professional asset managers, who can use it during standard Korean market hours or American hours to express a view on the U.S. equity market, to capitalize on relative value opportunities involving Korean and American equities (and indirectly global equities), and to expand the basket of investment positions available. Readers should also keep in mind that these broad approaches can be executed using options on both the KOSPI 200 futures and the E-mini S&P 500 futures. For more information on all CME Group Equity Index contracts visit cmegroup.com/equity. For more information on the KOSPI 200 futures and options visit krx.co.kr/index. Larry Morgan recently retired from the financial futures and options brokerage industry after a 33-year career assisting institutional clients in devising and executing hedging and trading strategies, primarily in fixed-income and currency markets. His clientele included commercial and investment banks, hedge funds, insurance firms, and corporate treasurers in North America, Europe, and East Asia. He has incorporated derivatives analysis and training throughout his career, instructing clients and others in the theory and practice of derivatives markets, as part of the instructional staff at Dean Witter Reynolds and in courses through the Korea Banking Institute in Seoul and at the People s University of Beijing. Before entering the brokerage profession, he was Senior Staff Economist at the Chicago Board of Trade. Currently, he s Adjunct Instructor in Economics at the City Colleges of Chicago. 5