Two in One
Strategically combining CME Group’s liquid equity index futures products creates another innovative set of risk management opportunities for market participants.
Sometimes the best combinations occur when you take something out.
The lack of a Russell 1000 futures contract at CME Group has created opportunities to use CME Group equity index futures in a variety of flexible hedging strategies, including synthetically replicating benchmark indexes that lack a liquid derivatives market.
In a white paper written in February 2008, Richard Co, CME Group director, financial research and product development, outlined effective ways to hedge the Russell 1000 index – which lacks robust liquidity – by relying on the liquidity in S&P 500 and S&P MidCap 400 Index futures to replicate a liquid performance of the Russell 1000 index.
“Strategic combinations are better for a large portfolio,” Co says. “In a less liquid contract, the larger portfolios lose enterprise, but in using the S&P 500 and S&P MidCap 400, the customers are paying less margin to buy and sell and can move sizeable liquid contracts.”
Co says the development of strategic combinations grew from conversations with customers who expressed an interest in more than just tracking – shadowing index performance – between indexes and futures. Some customers went even further, noting that the biggest hole in the index lineup was in the Russell contracts.
The construction of the combinations includes the mechanics – creating a product that will allow customers to accomplish their risk management needs – statistical analysis and intuition.
“There are only so many strategies you can explore, based on what’s trading,” Co says. “It’s also the statistical analysis of combination and checking against the understanding of how these contracts will work together.”
While the main line of the strategies has been the S&P 500 and S&P MidCap 400 futures for the Russell 1000 index, CME Group is looking to create more building blocks, or more combinations to replicate liquidity using equity index futures because, according to Co, there are more dimensions for strategies.
For instance, CME Group’s highly liquid futures contracts can create hedging opportunities for style indexes. A style index is a weighted index designed to provide a benchmark for a particular kind of strategy, such as growth, value or income. In the case of an index like the NASDAQ-100, the index contains more growth stocks than value. Traders looking for a growth-style index would overweight NASDAQ-100 futures and underweight S&P 500 futures. However, to gain exposure to a value index, subtract the growth component in the S&P 500 index by shorting NASDAQ-100 futures, according to Co.
Another possibility, which Co highlighted in a separate white paper, is spreading CME Group dollar-denominated and yen-denominated Nikkei 225 futures when looking at the contracts as relative valuations – comparing the price of one to the market value of its similar pair.
But outside the equity index futures realm, Co suggests there is more to be done, from rounding out the existing and possible tools to evaluate less liquid indexes and talking with customers about the expansion of strategic combinations within the equity index class, to exploring strategic combinations in other asset classes.
Either way, the opportunities are limitless.
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