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Related Keywords: Equity Index, Interest Rates, Strategies & Techniques
This article discusses how to maximize returns on an equity index futures strategy by using interest rate futures to reduce tracking errors from short-rate movements. The valuation of any equity index futures contract requires consideration of the interest rate environment. Portfolio managers who neglect this may be met with unwelcome tracking errors, which arise naturally from the interaction of short-term interest rate movements with daily marks-to market on futures. One can bring these tracking errors under control through judicious use of interest rate futures. This document reviews various strategies for doing so. The discussion is organized into five parts: Part one outlines how interest rate movements generate tracking errors that may undermine equity futures performance. Parts two and three explore how CME Group 30-day Fed Funds rate (FF) futures and Eurodollar (ED) futures, respectively, may be used to control this source of risk or, alternatively, to exploit it as a potential source of incremental return. Part four considers combinations of FF and ED futures. Part five measures the added transaction costs that a user would incur by combining interest rate futures with a core equity index futures position.
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