Overview of E-mini FTSE China 50 Index Futures

On October 12, 2015, CME Group will commence trading of E-mini FTSE China 50 Index futures. The FTSE China 50 Index measures the performance of Chinese companies listed in Hong Kong. It is constituted by including 50 of the most liquid and largest stocks, with a modified cap weighting to ensure broad representation.

The index futures will be listed on CME and will trade on CME Group’s electronic trading platform, CME Globex, virtually around the clock across the globe, giving investors worldwide access to this investment opportunity. The index will trade alongside other global index futures at CME Group, including E-mini S&P 500 Index futures, E-mini Dow Jones Industrial Average futures, Nikkei Index Futures, E-mini S&P Nifty Index Futures, iBovespa Index futures and other global benchmarks. The positions are cleared at CME Group’s clearing house, providing participants with capital and operational efficiency.

The contract is designed based on the quarterly index futures format that is familiar to index futures users around the world. The final settlement date is the third Friday of each quarterly contract months of March, June, September and December. The contracts will be settled to the official closing index value of the FTSE China 50 Price Index, which is calculated based on the Hong Kong Dollar closing price of the constituent stocks.

The contract features a USD $2 multiplier. As of this writing, each contract is roughly worth USD $33,000. Additional contract features are included in the specification table at the end of this article.

All China equity indices are not created equal. The FTSE China 50 Index comprises stocks listed in Hong Kong. More specifically, the index may include in its constituents H Shares, Red Chips and P Chips. There are few restrictions in participation in this stock market. International investors can trade in Hong Kong, as can eligible Qualified Domestic Institutional Investors from the PRC. The stocks are quoted and traded in Hong Kong Dollar (HKD).

The index is complementary to but distinct from the FTSE China A-50 Index, which measures the performance of China’s A-share market in Shanghai and Shenzhen. This market has a different set of participants, viz. domestic PRC investors as well as non-Chinese investors under the China Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investors (RQFII) schemes. The A-shares are quoted and traded in Chinese Yuan (CNY).

As a result of the inherent differences, prices of the A- and H-shares of the same company may follow different trajectories, subject to the distinct conditions and driving forces of each market. Inspecting the correlation table between various indices, it can be concluded that there was indeed a divergence between the two markets. The benchmarks for the A-share markets (CSI 300, FTSE China A-50) have a correlation of 0.94 between them, but each has only a correlation of approximately 0.59 with the FTSE China 50.

*Total Returns are calculated based on local currency as of August 31, 2015. Historical volatility, kurtosis, skewness, max and min 1-day move based on daily price return from January 3, 2011 to October 12, 2016.

Similar analysis shows that the common constituents between FTSE China 50 Index and the Hang Seng Index are also significant. Some non-H-share constituents in FTSE China 50 are components of Hang Seng.

*Note that the stocks of the same company included in FTSE China 50 and FTSE China A50 Indices are the H-shares and A-shares respectively. They are separate tranches of stocks.

Data as of October 12, 2016

A multiple regression based on four years of daily returns of these indices suggests a very strong statistical relationship. Based on a regression analysis¹ ,

RFTSE China 50 = 0.68 RHSCEI + 0.36 RHSI + Residuals

                                      (0.01)                    (0.01)

the R2 of the regression exceeds 0.98. The standard error estimates are one order of magnitude smaller. This suggests the FTSE China 50 index has a very stable relationship with the other two Hong Kong and China benchmarks.

In contrast, the common constituent count and weights between the FTSE China 50 and FTSE China A-50 Indices are similar in magnitude than those amongst FTSE China 50 and HSCEI. The correlation, however, is much lower. This serves as a proof that the A- and H-share markets are perhaps marching to quite different beats.

The summary statistics table compares the performance between the five benchmarks. Note that the A-share markets have much higher tail risks (much higher kurtosis, larger max one-day downside moves) when compared with the Hong Kong market. These tail risks tend to be on the downside (more negative skewness).

During the Hong Kong trading hours, there are plenty of cross-hedging vehicles in the short run. For example, the underlying cash market is open, as well as index futures based in Hong Kong on the two other aforementioned benchmarks. It is worth pointing out that:

• Valuation timing can be different between Hong Kong and the U.S.: settlement cycles are different between the two market locations. As such, even if a spread between Hong Kong and U.S. markets is established, there is a sizeable timing difference between when the daily settlement is established in Hong Kong versus when it’s established in the U.S. Even if the market remains calm and the valuation for the products remains unchanged in the interim, the settlement cycle for CME’s E-mini FTSE 50 Index futures can be delayed by one business day;
• Market events in the interim can introduce misalignment of the mark-to-market valuations, despite the fact that they are referencing very similar sets of underlying securities;
• There could be also market holiday differences that can cause further dislocations. These dislocations are temporary in nature, of course. When both markets are open again simultaneously, valuations will realign themselves.

During the U.S. trading hours, there is also a layoff market for the product. The FTSE China 50 Index ETF is listed for trading in the U.S. stock market (ticker symbol: FXI). As of this writing, the ETF has a market capitalization of approximately USD $3.9 billion, and a 30-day average turnover of approximately USD $280 million. As such, there could be a symbiotic relationship between the futures and ETF markets during the non-Hong Kong trading hours.

Compared to the cross-trading of Hong Kong and U.S. instruments, trading U.S. ETF and E-mini FTSE China 50 Index futures does simplify the valuation timing issue:

• Both the ETF and the E-mini FTSE China 50 Index futures are marked to market at the close of business in the U.S. As such, the valuation tends to be aligned;
• To the extent margin requirements are set between ETFs and futures; however, the net amount of margin while spreading trading different index futures, even in different jurisdiction, could be lower.

In aggregate, there are approximately USD $7 billion in assets under management currently indexed to the FTSE China 50 Index². E-mini FTSE China 50 Index futures can perform a meaningful risk management function as well as a price discovery function for this market segment.

Looking forward, the dichotomy of investment philosophy for international investors regarding whether to invest in the A-share or Hong Kong market can persist for a period of time. Some institutional investor follows a broader world equity benchmark that includes the A-shares market, where a more stringent set of market access rules applies. Others retain investment mandates in which investments need to be made in markets for which access is more open. As this debate continues, the FTSE China 50 Index remains a bridge to the two philosophies.

Trading all of your equity index futures at CME Group has a distinct advantage in the form of operational and capital efficiencies.

• All margin collateral is deposited into a single clearing house at CME Group. At the end of each trading day, there is only one net variation margin requirement, as opposed to having to wire multiple transfers to meet different requirements. This greatly simplifies operations and provides efficiency of scale for the margin capital.
• At the launch of the product, indicative margin calculation shows potentially a 45 percent margin reduction³ for E-mini FTSE China 50 Index Futures vs. Nikkei Futures traded at CME Group. Cross-margining with other products may become available as the market develops.

¹ Data from January 3, 2011 – October 12, 2016. The constant term in the regression is very close to zero and is statistically insignificant. It is suppressed in the regression result.

² Data as of October 12, 2016

³Margin requirements and margin breaks for products eligible for cross-margining are subject to change and maybe revised without advanced notice. Please consult www.cmegroup.com for the latest margin requirement information.