Risk Management for Equity Asset Managers John W. Labuszewski
Disclaimer Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only a percentage of a contract s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. The Globe Logo, CME, Chicago Mercantile Exchange, and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and the Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange, and ClearPort are trademarks of New York Mercantile Exchange, Inc. COMEX is a trademark of Commodity Exchange, Inc. CME Group is a trademark of CME Group Inc. All other trademarks are the property of their respective owners. The information within this presentation has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Although every attempt has been made to ensure the accuracy of the information within this presentation, CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this presentation are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME, CBOT, NYMEX and CME Group rules. Current rules should be consulted in all cases concerning contract specifications. 6
Outline Market Development Mechanics of Stock Index Futures Fair Value and Arbitrage Measuring Risk Beta Adjustment Strategies Long/Short Strategy Portable Alpha Strategy Efficient Beta 7
Market Development Stock index futures Cash settled at $X multiplied by Index value E.g., E-mini S&P 500 futures valued at $50 x Index If S&P 500 = 1,318.80, futures valued at $65,940 ($50 x 1,318.80) Quoted in index points in increments of 1 tick E.g., 1 tick in E-mini S&P 500 futures = 0.25 index points or $12.50 (= $50 x 0.25) Major E-mini Equity Futures ADV 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 E-mini S&P 500 E-mini Nasdaq-100 E-mini ($5) DJIA E-mini S&P MidCap 8
Market Development Trends contributing to growth S&P 500 = asset class benchmark with $5-6 trillion linked assets Low rates, poor equity returns prompt search for alpha over benchmark return shift from passive to active strategies see hedge fund growth CME Globex fosters liquidity low transaction costs in transparent, competitive electronic trading venue Open access policy offers direct access to Globex on global basis Handles > 1 billion orders monthly with average response < 20 milliseconds Financial sureties offered by CME Clearing House Counterparty credit risk is significant particularly after subprime crisis Centralized counterparty (CCP) clearing = financial confidence & capital efficiency 9
Market Development Electronic trading CME Globex originally introduced in 1992 to facilitate after-hour trading Open access policy introduced in 2000 allows any customer to trade directly on system 85% of all CME Group volume is electronic Growth during past decade largely attributable to electronic trading... this enhances liquidity 16,000,000 14,000,000 12,000,000 10,000,000 8,000,000 6,000,000 4,000,000 2,000,000 0 Traditional vs. Electronic ADV 69% 79% 81% 83% 84% 85% 64% 52% 61% 31% 42% 8% 17% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Traditional ADV Electronic ADV 10
Mechanics of Stock Index Futures Popular stock index futures Contact Multiplier Minimum Price Fluctuation (Tick) Price Limits Contract Months Trading Hours Trading Ends at Cash Settlement Position Limits or Accountability E-mini S&P 500 $50 x S&P 500 Index 0.25 index points ($12.50) 100,000 E-mini S&P contracts E-mini Nasdaq-100 $20 x Nasdaq-100 Index 0.50 index points ($10.00) E-mini S&P MidCap 400 $100 x S&P MidCap 400 0.10 index points ($10.00) Limits at 7%, 13%, 20% moves 1 st 5 months in March quarterly cycle Mon Thu: 5:00 PM (previous day) to 4:15 PM with trading halt between 3:15 PM and 3:30 PM 8:30 am on 3 rd Friday of month vs. Special Opening Quotation (SOQ) 50,000 E-mini S&P contracts 25,000 E-mini MidCap contracts E-mini DJIA ($5) $5 x Dow Jones Industrial Avg 1.00 index points ($5.00) 1 st 4 months in March quarterly cycle 100,000 E-mini DJIA contracts Ticker ES NQ ER YM 11
Mechanics of Stock Index Futures E-mini S&P 500 pricing (4/23/13) Month Open High Low Settlement Interest Open Change Volume Jun-13 1,557.25 1,527.00 1,548.75 1,573.60 +17.70 2,108,113 2,984,052 Sep-13 1,550.25 1,570.50 1,543.00 1,567.60 +17.80 14452 41661 Dec-13 1,549.25 1,563.50 1,536.50 1,561.10 +17.80 60 2438 Mar-14 1,532.50 1,555.00B 1,530.25 1,554.90 +17.80 10 27 Jun-14 1,544.25B 1,529.25 1,547.90 +17.80 1 2,122,635 3,028,179 Value of futures contract Futures Contract Value = Contract Multiplier x Quoted Value = $50 x 1,573.60 = $78,680 12
Mechanics of Stock Index Futures Cash settlement mechanism Futures Marked-To-Market (MTM) like any other day, i.e., pay losses and collects profits daily and in cash Subsequent to final settlement day, positions simply expire and are settled at spot value of underlying index or instrument The Final Settlement Price is marked to a Special Opening Quotation (SOQ) on the 3rd Friday of the contract month SOQ is intended to facilitate arbitrage activity by allowing arbitrageurs to enter market on open (MOO) orders to liquidate cash positions at same price that will be reflected in the Final Settlement Price A morning settlement was established in late 1980s to avoid so-called triple witching hour 13
Fair Value and Arbitrage Fair value (FV) of futures contract Futures Price = Spot Index Value + Finance Charges - Dividends This difference reflects the expected premium or discount at which futures are expected to trade relative to the spot index value often referred to as Fair Value Basis (=futures price spot price) normally expected > 0 Normally, we expect short-term rates > dividend yields negative carry as finance costs exceed dividend payouts Sometimes rates < dividend yields and basis goes negative positive carry as finance costs exceed dividend payouts 14
Fair Value and Arbitrage Basis driven by carry Relationship between shortterm interest rates and dividends dictate whether positive or negative carry prevails 7% 6% 5% 4% 3% 2% 1% Short-Term Rates & Dividend Yields 0% Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 Jul-11 Jan-12 Jul-12 Jan-13 1-Mth LIBOR S&P 500 Dividend Yield 15
Fair Value and Arbitrage Cost of Carry If dividend stream < finance costs negative carry Futures at higher levels in deferred months reflecting costs incurred carrying stock portfolio If dividend stream > finance costs positive carry Futures at lower levels in deferred months reflecting dividend earnings carrying stock portfolio 60 40 20 0-20 -40-60 Positive and Negative Carry Negative Carry Positive Carry t+0 t+1 t+2 t+3 t+4 t+5 t+6 t+7 16
Applications Multiple uses and users Retail Traders Proprietary Traders Arbitrageurs Asset Managers Outright Price Speculation Arbitrage aka Program Trading Cash Equitization Beta Adjustment Option Strategies Long/Short Strategies Sector Rotation Conditional Rebalancing Portable Alpha 17
Measuring Risk Seeking alpha (α) Domestic equities have been volatile but have not produced sizable returns over past decade Equity managers faced with challenge of generating attractive returns while managing risk Stock index futures and options provide effective tool in search for alpha S&P 500 S&P 500 Index & VIX 1,700 1,650 1,600 1,550 1,500 1,450 1,400 1,350 1,300 1,250 Jan-12 Mar-12 May-12 Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 S&P 500 VIX 28% 26% 24% 22% 20% 18% 16% 14% 12% 10% VIX 18
Measuring Risk Capital Asset Pricing Model (CAPM) Total Risk = Systematic Risks + Unsystematic Risks Systematic risk refers to market risks reflected in economic conditions affecting all stocks Unsystematic or firm-specific risks are factors that uniquely impact upon specific stock Beta analysis statistical regression to define relationship between individual stock and market returns R stock = α + β (R market ) + ε 19
Measuring Risk Beta (β) analysis Beta (β) identifies expected relative movement between an individual stock and market If β > 1.0 Aggressive stock If β < 1.0 Conservative stock R 2 identifies the degree to which movements in the stock are explained by market movements varies between 0 and 1.0 If R 2 = 1.0 Perfect correlation If R 2 = 0 Zero correlation Average stock R 2 0.30 which implies that perhaps 30% of movements explained by systematic factors remaining 70% of unsystematic risks unhedgeable with macro index futures 20
Measuring Risk Measuring beta (β) Apple (AAPL) had raw β=0.9259 conservative stock R 2 = 0.2664 implying that only 27% of its movement attributed to systematic market risks Stock Returns 20% 15% 10% 5% 0% -5% -10% AAPL v. S&P 500 Weekly Returns (Apr-11 - Mar-13) y = 0.9259x + 0.0013 R² = 0.2664-15% -8% -6% -4% -2% 0% 2% 4% 6% 8% S&P 500 Returns 21
Measuring Risk Measuring beta (β) General Electric (GE) had raw β=1.1834 aggressive stock R 2 = 0.7325 implying that only 73% of its movement attributed to systematic market risks FASB 133 allows hedge accounting, i.e., simultaneous recognition of returns in hedged item with hedging vehicle, if R 2 0.80 GE v. S&P 500 Weekly Returns (Apr-11 - Mar-13) 12% 10% 8% 6% 4% 2% 0% -2% -4% y = 1.1834x - 0.0003-6% R² = 0.7325-8% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% S&P 500 Returns Stock Returns 22
Measuring Risk Hypothetical Stock Portfolio (3/29/13) Hypothetical portfolio Constructed from 38 top stocks in S&P 500 Portfolio valued at $100,010,954 with valueweighted adjusted β = 0.988 Ticker Shares Price Value Adj β 1 XOM $90.11 50,000 $4,505,500.00 0.993 2 AAPL $442.66 18,000 $7,967,880.00 0.950 3 GE $23.12 175,000 $4,046,000.00 1.123 4 CVX $118.82 40,000 $4,752,800.00 1.085 5 IBM $213.30 12,000 $2,559,600.00 0.926 6 MSFT $28.61 100,000 $2,860,500.00 0.912 7 JPM $47.46 75,000 $3,559,500.00 1.299 8 PG $77.06 56,000 $4,315,360.00 0.638 9 JNJ $81.53 60,000 $4,891,800.00 0.656 10 T $36.69 50,000 $1,834,500.00 0.750 11 WFC $36.99 75,000 $2,774,250.00 1.168 12 PFE $28.86 98,000 $2,828,280.00 0.794 13 KO $40.44 46,000 $1,860,240.00 0.702 14 BRK/B $104.20 34,000 $3,542,800.00 0.875 15 BAC $12.18 100,000 $1,218,000.00 1.555 16 C $44.24 100,000 $4,424,000.00 1.765 34 UPS $85.90 19,000 $1,632,100.00 0.888 35 CMCSA $41.98 54,000 $2,266,920.00 1.072 36 MMM $106.31 14,000 $1,488,340.00 0.984 37 CAT $86.97 12,000 $1,043,640.00 1.321 38 HD $69.78 32,000 $2,232,960.00 0.959 Portfolio $100,010,954 0.988 23
Measuring Risk Measuring beta (β) Portfolio had raw β=0.982 a conservative portfolio R 2 = 0.9737 implying that 97% of its movement attributed to systematic market risks Because R 2 > 0.80, portfolio considered hedge-able with macro index futures and should qualify for hedge accounting treatment per FASB 133 Stock Returns 10% 8% 6% 4% 2% 0% -2% -4% -6% Portfolio v. S&P 500 Weekly Returns (Apr-11 - Mar-13) y = 0.982x - 0.0001 R² = 0.9737-8% -8% -6% -4% -2% 0% 2% 4% 6% 8% S&P 500 Returns 24
Beta Adjustment Strategies Selling futures 50 Hedged with Short Futures Vs. stock portfolio allows one to reduce risk exposure as measured by beta Because futures are leveraged, fully hedged portfolio expected to generate S-T rate of return Profit/Loss 40 30 20 10 0-10 -20-30 Equity Values Decline Equity Values Advance Sell futures Reduce risk exposure measured by β -40-50 1,280 1,282 1,284 1,286 1,288 1,290 1,292 1,294 1,296 1,298 1,300 1,302 1,304 1,306 1,308 1,310 1,312 1,314 1,316 1,318 1,320 1,322 1,324 1,326 1,328 Index Value 1,330 1,332 1,334 1,336 1,338 1,340 1,342 1,344 1,346 1,348 1,350 1,352 1,354 1,356 1,358 1,360 Equity Portfolio Fully Hedged Partially Hedged 25
Beta Adjustment Strategies Hedge ratio (HR) Where HR = (β target β current ) x (Value portfolio Value futures ) β target = targeted portfolio beta β current = current portfolio beta Value portfolio = monetary value of portfolio Value futures = monetary value of stock index futures contract, e.g., for E- mini S&P 500 futures Value futures = $50 x Index 26
Beta Adjustment Strategies E.g., market believed to be overvalued, reduce β from 0.988 to 0.900 Value futures = $78,135 (= $50 x 1,562.70) THUS strategy is sell 113 futures HR = (0.900 0.988) x ($100,010,954 $78,135) = -113 E.g., market believed to be undervalued, increase β from 0.988 to 1.100 THUS strategy is buy 143 futures HR = (1.100 0.988) x ($100,010,954 $78,135) = 143 Sell 113 futures Reduces β from 0.988 to 0.900 Buy 143 futures Increases β from 0.988 to 1.100 27
Long/Short Strategy 130/30 strategy Uses leverage to purchase shares with expected high returns and shorting stocks with expected poor returns 130/30 means buying stocks worth 130% of fund value; shorting stocks worth 30% of fund value Other ratios also used, e.g., 120/20, 140/40, etc. Investors often reference returns on benchmark index (e.g., S&P 500) as strategy bogey Rank order all 500 stocks in index by fundamental performance criteria buy stocks at top of list, sell stocks at bottom of list Conceptually similar to pairs trading but on larger scale 28
Long/Short Strategy 130/30 strategy, cont. Buy-and-hold S&P 500 futures notionally valued at 100% of AUM Buy superior stocks, funded by shorting inferior stocks valued @ 30% of AUM Futures provide core beta performance with liquidity and cash management flexibility LONG S&P 500 futures notionally valued at 100% of Assets Under Management (AUM) LONG Superior stocks @ 30% of AUM SHORT Inferior stocks @30% of AUM Buyand-hold futures Replicate core or beta portfolio performance with cash management flexibility 29
Portable Alpha Strategies Defining portable alpha Objective outperform benchmark returns by adding alpha Risk that alpha strategy may not outperform LIBOR Active trading strategies or hedge funds often used to capture alpha Must capture beta efficiently Futures or swaps used passively to capture beta need efficient beta i.e., low tracking error and low transaction costs Alpha Create returns > LIBOR thru active trading Alpha Create returns > LIBOR thru active trading Beta Capture core or beta returns by passively holding S&P 500 futures or other derivatives 30
Portable Alpha Strategies Buy-and-hold S&P 500 futures to capture beta Performance bond (aka margin ) for E-mini S&P 500 futures may be 5-15% of notional contract value contingent on volatility 85%-95% residual available for investment Invest residual 85%-95% of contract value in an alpha generating strategy E.g., actively managed investment fund, hedge fund, commodity fund, real estate, tactical asset allocation strategy Some popular portable alpha funds trade short-term interest rate instruments to capture alpha on top of S&P 500 core investment Buy-and-hold futures Replicate core or beta portfolio performance with cash management flexibility 31
Portable Alpha Strategies Hierarchy of capital efficient alpha strategies Ranking investment strategies on basis of alpha potential per capital deployed Active, aggressive strategies require more trading skill Still, it s difficult consistently to deliver alpha Overlay Strategies E.g., tactical asset allocation Absolute Return Strategies E.g., hedge funds, commodity funds, real estate Traditional Active Management E.g., active small cap Passive Indexing E.g., index mutual fund 32
Portable Alpha Strategies Hedge funds Hedge funds often used as source of alpha with 2012 return = +6.16% AUM up to $2.253 trillion with number of funds (exfund of funds) at 7,940 by conclusion of 2012 Assets Under Mgt (Bil) $2,400 $2,000 $1,600 $1,200 $800 $400 $0 Size of Hedge Fund Industry 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 # of HFs (ex-fofs) Assets Under Mgt Source: Hedge Fund Research 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 No. of Hedge Funds 33
Efficient Beta Two factors contribute to efficient beta Low tracking error May be measured by end-of-day (EOD) mispricing CME Group eliminates end-of-money (EOM) mispricing thru fair value settlement process Calendar spread mispricing impacts cost of rolling passive long position from nearby to deferred contract month Low transaction costs Brokerage commissions and exchange fees contribute to transaction costs but largest component is execution skids or slippage a function of liquidity Liquidity may be measured by width of bid/ask spread Or, by market depth or number of limit orders resting in central limit order book (CLOB) 34
Efficient Beta Low tracking error CME products enjoy low end-of-day (EOD) mispricing or tracking error Fair value settlement process essentially eliminates tracking error on last day of month Basis Points 40 30 20 10 0-10 -20-30 E-mini S&P 500 E-mini Nasdaq-100 Average End-of-Day Mispricing (3 Months ending Mar-13) CME Group Products E-mini MidCap E-mini ($5) DJIA ICE Russell 2000 Brazil Bovespa Mexico Bolsa Idx DJ Euro STOXX FTSE 100 DAX 30 Nikkei 225 (OSE) TOPIX Hang Seng Kospi 200 TAIEX S&P CNX Nifty MSCI EAFE MSCI EM Source: GS Futures Focus Monthly 35
Efficient Beta Eliminating end-of-month tracking error End-of-month (EOM) settlement at fair value (FV) Based on survey of interest rates and dividends E.g., on 3/28/13, rate @ 0.350; 84 days from 4/3/13 settlement to expiration of Jun-13 contract; S&P 500 @ 1,562.85; dividends @ at 7.831 index points Fair Value = Finance Charges - Dividends = Rate x (days/360) x Index Value - Dividends = 0.350% x (84/360) x 1,562.85-7.831 = -6.555 Futures settled at 6.555 discount under index @ 1,556.30 36
Efficient Beta Market width Bid-ask spread in E-mini S&P 500 futures for 500- lot order averaged $21.52 in Jun-13 Tick size = 0.25 index points ($12.50) Bid-Ask in $s per Contract $40 $35 $30 $25 $20 $15 E-Mini S&P 500 Market Width Lead Month on CME Globex RTH 50% 40% 30% 20% CBOE VIX Index $10 10% Jul-09 Nov-09 Mar-10 Jul-10 Nov-10 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 S&P 500 VIX Index 50 Cnt Width 100 Cnt Width 200 Cnt Width 500 Cnt Width 1,000 Cnt Width 37
Efficient Beta Market depth 313 contracts shown at top-of-book for E-mini S&P 500 in Jun-13 Depth in Contracts 12,000 10,000 8,000 6,000 4,000 2,000 0 E-Mini S&P 500 Market Depth Lead Month on CME Globex RTH 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000 0 Jul-09 Dec-09 May-10 Oct-10 Mar-11 Aug-11 Jan-12 Jun-12 Nov-12 Apr-13 Avg Daily Volume Top-of-Book Qty 2nd Level Qty 3rd Level Qty 4th Level Qty 5th Level Qty Avg Daily Volume 38
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