... and swaps, and why maybe you

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1 Old-fashioned is sometimes better than all this new-fangled stuff... The sloppy connection between ETPs and futures contracts... and swaps, and why maybe you should stay away from these assets , Gary R. Evans. May be used only for non-profit educational use without permission of the author.

2 How a delta ETP can be collateralized with futures contracts the rules Remembering that Maximum leverage = Notional Value / Initial Margin The actual leverage you earn is Actual leverage = Notional Value / Cash in account 1. A long ETP holds long futures contracts, an inverse holds short futures contracts. 2. For a 1X ETP, Notional Value = Cash in account 3. For a 2X ETP, Notional Value = 2X Cash in account 4. For an αx ETP, Notional Value = αx Cash in account 5. Assets of the ETP equals the cash, not the notional value of the futures contracts. The size of the initial & maintenance margins are not relevant.

3 etting on Oil with ETPs... DNO Assets $16,060, SO: 450,000 NAV: $35.69 USO Assets $926,150, SO: 27,300,000 NAV: $33.92

4 Asset Holdings of the UGA RO gasoline delta tracking stock Which are the assets?? Note that the Net Assets of UGA do not sum to the total of the notional value of the futures contracts plus cash and other liquid assets. The futures contract is not an asset. Cash and the Treasury ill make up the assets for this ETP. Source: United States Gasoline Fund of the funds featured at on the date above.

5 USL a more complex contract

6 Using these rules, let s build our own ETPs!! Contract Size: Initial Margin: Cash available: Price now: uilding four Gold ETPs 100 Troy ounces $8,800 $100M Date: 19-Nov-13 Target Futures posture Number of contracts Total Notional Value Memo: Total Initial Margin IM as % of cash 1X long L 785 $100,048,250, $6,908,000, 6.91% 3X long L 2354 $300,017,300 $20,715, % 1 X short S 785 -$100,048,250 $6,908, % 3X short S $300,017,300 $20,715, %

7 Hedging Hedging, especially when using derivatives, involves the purchase or sell of a derivative for the purpose of reducing risk - sometimes substantial risk. Here is a typical hedging problem: You are a jewelry manufacturer. You use silver in the manufacture of your film, and anticipate using about 10,000 troy ounces in July. You have nice margins and you don t want an unexpected increase in the price of silver to reduce or eliminate those margins. How should you use the futures market to hedge your position?

8 What you need to know and decide... Which h future on which h market? What is the contract size... and dhow many contracts t do you need? Long or short? What is your initial iti and maintenance margin... and hence your cash requirement for the hedge? Are you going to take delivery?

9 ut... (a rather important point) Futures contracts can be used to hedge against rising (or falling) prices and inflation in general, but if inflationary expectations are robust and inflationary expectations are already priced in futures prices, no good hedge or no hedge at all will be available! That's why when hedging is part of your business or investment strategy, you must either hedge all of the time (including when it may look like you least need to hedge), which involves some cost, or you have to be confident that you have an edge and can move into the market before inflationary expectations push up the price of futures contracts. When futures prices rise as the contracts get more distant, the media and analysts sometimes call this a contango (see the example next slide). The opposite is called "backwardation." [Technical note: In derivatives math modeling, a contango exists only when the futures price is above the expected future spot price, but the media ignores such refinements. Econ 136 sorts this out].

10 The oil contango of late 2008 This is a 31% spread, far beyond any carry cost! Source: ino.com... can you effectively hedge when this contract is in contago??

11 The problem with Contango futures for delta ETFs: tracking bias S S S From a previous slide: Oil in Contango in 2008: S S During times when the futures u contracts are in Contango (example shown for oil in 2008) then all futures are well above spot and all go subsequently higher h with duration. These contracts must be rolled over. Therefore you are tending to buy higher than settlement if spot doesn t rise enough to cover the spread. S S

12 Figure 14: Example of a Contango Introducing Tracking ias into a Delta Tracking ETF Secured with Futures 90 S S 90 S S S 99 S 102 The point: Will a commodity-based ETF that invests in futures see its NAV rise if the spot value of the commodity that it tracks rises month after month? No, is the answer if the futures contracts have a contango built in. In the example above, the NAV stays flat!

13 ETNs and Swaps... the new red flag A i t t ith 3 rd t h i t di t f A swap is a contract with a 3 rd party who promises to pay you according to a performance metric (such as 1X inverse DOW) in exchange for a fee, like LIOR + 3%. The 3 rd party uses the futures contracts... maybe.