Trading China Exposure: Index Arbitrage and Futures Bases

For each data point, the futures “arbitrage-free” prices were calculated.² The futures prices were then compared to these theoretical arbitrage-free prices. The horizontal and vertical axes represent the deviation of HSCEI and HSI index futures from their respective theoretical prices. For example, at a particular point in time, if the HSI futures are 0.5% above theoretical value and the HSCEI futures are 0.5% below theoretical value, it will be represented as a blue dot on the top left quadrant at (-0.5%, 0.5%).

During this sampling period, the correlation between HSI and HSCEI was at or above 0.95 – as illustrated in Figure 2. While the two contracts tend to trade “rich” or “cheap” to their respective fair value simultaneously, it is apparent that one futures contract can be trading “rich” while the other is trading “cheap”. In fact, the R-square of the regression is only 0.27..

These conditions are results of temporary imbalance of end investor demands, e.g. rotation of interest in and out of China-specific securities. These temporary imbalances revert quite often. As a result, there are plenty of trading opportunities.

The addition of the E-mini FTSE China 50 index futures adds another layer of trading opportunities to the existing set of trading instruments; as referenced earlier, participants in the FTSE China 50 ETF listed in the U.S. (FXI) can use futures to manage their exposure. This trading opportunity extends beyond Hong Kong trading hours, as the index arbitrage between the U.S.-listed ETF and the E-mini FTSE China 50 Index futures continues. As the latter continues to gain traction, trading opportunities will certainly expand for all market participants.

As of the end of March 31, 2016, the FTSE China 50 Index consisted of the following constituents:

The fair value, or theoretical level at which futures should be expected to trade, is a function of the cash index value plus implied financing, less dividends paid over the life of the contract:

Fair Value = Spot + Financing Advantage – Foregone Dividends

Unlike the buyer of a cash basket of index securities, who must finance the full notional value of the trade at inception, the buyer of a futures contract must only post a fraction of the notional as margin, and can invest the remaining cash in an interest-generating instrument. At the same time, the seller of futures must replicate the index returns. The amount of financing advantage above the cash basket depends on the interest rate (e.g. Interbank offer rate), as well as the time to expiration of the futures, and is reflected in the futures price. The magnitude of the financing advantage will shrink over time, until it reaches zero on the expiration day of the futures contract.³

Mathematically, the financing advantage is:

Spot Index x Interest Rate Benchmark x Time to Futures Expiry

Conversely, the buyer of a cash basket is entitled to dividend payments, while the buyer of futures is not. As a result, futures prices are adjusted downward by the amount of this foregone dividend stream to reflect this disadvantage to the buyer. Much like the financing advantage, the foregone dividend also shrinks over time, until it reaches zero on the expiration day of the futures contract.⁴

Hence, equity index futures trade at a premium or discount (known as the basis) relative to the cash index level, depending on whether the implied financing is greater or less than expected dividends over the duration of the contract.

Most CME Group index futures, including E-mini FTSE China 50 Index futures, can be traded through a Basis Trade at Index Close (BTIC) mechanism. The buyer and seller consummate the initial trade in terms of the basis,

i.e. the difference between futures price and the spot index. This is the same as the financing advantage less the foregone dividends. At the close of trading in the cash security market, the closing index value is known. The trade of the index futures will be concluded at the price of the closing index value plus this basis.

In essence, this mechanism allows participants to trade at fair value based on the closing index value of the day. For more information, please visit cmegroup.com/btic.

Market participants monitor the fair value and capitalize on price discrepancies between spot and futures levels by purchasing the cheaper alternative and selling the more expensive one. This activity, known as index arbitrage, prevents futures from trading far above or below fair value.

Futures and cash index value are publicly observable variables. Dividend streams are highly forecastable as company paying dividends would declare the dividend ahead of the ex-dividend dates. Given these quantities, the only “free” variable is the financing rate priced in by the relative prices of futures and cash index. It is thus customary to describe the market as “rich” if the implied financing rate of futures is higher than benchmark interbank financing rates. Conversely, the market is described as “cheap” if the implied financing rate5 is lower than the benchmark interbank financing rates.

When the futures price is trading “rich” or above its fair value, the premium over the spot price paid by the buyer of futures is greater than the actual cost to buy the cash basket until maturity. In this scenario, traders can sell short the futures and purchase the cash basket, thereby exerting downward pressure on the futures price and pushing upward on the cash index level until the actual basis is brought in line with fair value.

Alternatively, when the futures price is trading “cheap” or below its fair value, traders can buy the futures and sell short the underlying stocks to reestablish equilibrium. This scenario differs slightly in that a short sale of securities requires a loan of shares to sell short by a prime broker.

In reality, the costs associated with executing the arbitrage result in a no-arbitrage band within which the prices of spot and futures move without creating an arbitrage. In  the scenario where futures are “cheap”, the short sale of securities requires a loan of shares to sell short by a prime broker. This borrow cost, quoted as an annualized fee, can vary significantly depending on the number of lenders and the demand for borrow, and must be known before evaluating the arbitrage opportunity. For example, if the broker fee is 50bps for borrowing the basket of securities to sell short, the implied financing cost of futures must be at least 50bps in order for the arbitrage to be attainable.

¹ A more thorough explanation of fair value is detailed in Appendix A.

² Futures prices were calculated based on the then current index value and the 1-month HIBOR as the interest rate benchmark.

³ Another way to interpret this futures premium due to financing advantage is to see it as the cost of leverage being grossed up and added to the price of the futures contract. As this gross-up amount declines, the financing cost is paid.

⁴ Alternatively, you can interpret the reduction of the discount of futures price due to foregone dividend as constructively receiving the foregone dividend via capital gains, as the futures price drifts up over time.

⁵ The "richness" or "cheapness" is the most apparent into the "roll market", in which traders swap the front month position for a back month position. These calendar spread trades are purely driven by the implied financing rate. See, for example, the quarterly roll monitor at CME Group's website for U.S. indices: www.cmegroup.com/rollpace.