- 17 Aug 2018
- By David Gibbs
A simple explaination of index replication
The introduction of equity index futures in 1982 opened a new door for passive index investors by giving them an effective, efficient tool to replicate their core beta while allowing them to retain cash for operational and alpha- generating purposes. This type of investment strategy is commonly employed and outlined in the prospectus disclosures of indexed mutual funds and ETFs. Investors
can use futures to establish their benchmark equity index exposure, benefit from the leverage and use the freed-up capital to deploy alpha-generating strategies.
With the launch and development of CME Bitcoin futures (BTC), which in July 2018 averaged over 6,200 contracts per day (approximately 31,000 equivalent bitcoins; +$230 million in notional value 1 ), the strategy can be easily adapted by crypto-fund managers.
Consider a crypto fund manager of an $8 million fund that is benchmarked to the CME CF Bitcoin Reference Rate (BRR). She wants to replicate 100% of the fund’s value in BTC futures and retain cash for income-generating (alpha) activities.
The manager can use BTC futures which represent the financial equivalent of five -bitcoin in notional value to gain exposure. Futures contracts do not require full payment of notional value prior to purchase. They require performance bond, also known as margin, for open positions. If we assume BTC is at $8,000 per bitcoin and the margin on one BTC contract is $17,2002, a beta replication strategy can be constructed. The manager can obtain the desired exposure by buying the notionally equivalent number of futures and using the excess capital to invest in interest bearing securities.
For example, the crypto fund manager who wants to replicate 100% of her fund using BTC calculates the notional value of one BTC contract:
NV (BTC) = $8,000 per bitcoin x 5 bitcoin = $40,000 per contract
Thus, $8,000,000 / $40,000 = 200 BTC contracts to replicate 100% exposure, keeping the fund fully exposed to its benchmark. Two hundred BTC contracts require $3,440,000 in margin to CME Clearing (200 x $17,200) allowing the manager to employ the remaining balance of $4,560,000 in cash to alpha-seeking investments.
Assume over the course of a year that the BRR trades off by 5% to roughly 7,600. The fund loses 5% of its value, a
$400,000 loss. If the cash funds invested in money market equivalents earned 2% interest 3, they would have produced
$91,200 in income for the fund. Subtracting the $91,200 income from the $400,000 produces a loss of $308,800, or 3.9%4 loss, rather than 5.0 %. In other words, the fund beat the index benchmark (and potential competitors) by 1.1%.
Would that improvement over benchmark make a difference to the fund’s investors or potential investors? Looking at how equity index futures influenced the growth of index funds, it is certainly worth investigating how CME Bitcoin futures might be used by crypto funds for BRR beta replication.
Contract Unit |
5 bitcoin, as defined by the CME CF Bitcoin Reference Rate (BRR) |
|---|---|
Minimum Price Fluctuation |
Outright: $5.00 per bitcoin = $25.00 per contract Calendar Spread: $1.00 per bitcoin = $5.00 per contract |
Trading Hours |
CME Globex and CME ClearPort: 5:00 p.m. – 4:00 p.m. CT Sunday – Friday |
Product Code |
Outright: BTC |
Listing Cycle |
Nearest 2 months in the March Quarterly cycle (Mar, Jun, Sep, Dec) plus the nearest 2 “serial” months not in the March Quarterly cycle. |
Termination of Trading |
Last Day of Trading is the last Friday of contract month. Trading in expiring futures terminates at 4:00 p.m. London time on Last Day of Trading. |
Position Limits |
Spot Position Limits are set at 1,000 contracts. A position accountability level of 5,000 contracts will be applied to positions in single months outside the spot month and in all months combined. |
Block Minimum |
5 contracts |
Price Limits |
Price limits for a given Business Day are made by reference to the most recent Bitcoin Futures settlement price, settled at 3:00 p.m. Central Time each Business Day. Special price fluctuation limits equal to 7% above and below prior settlement price and 13% above and below prior settlement price and a price limit of 20% above or below the previous settlement price. Trading will not be permitted outside the 20% above and below prior settlement price. |
Settlement |
Cash settled by reference to Final Settlement Price, equal to the CME CF Bitcoin Reference Rate (BRR) on Last Day of Trading. |
1 As of July 2018
2 FCM may require additional margin over what CME Clearing requires.
3 CME pays interest on cash held for collateral purposes so additional income could be generated through the margin account. Additionally, the manager may choose to post securities or favorable combination of securities and cash to further increase the amount of funds available to deploy in alpha-generating strategies.
4 Futures have a daily mark-to-market, known as variation margin (VM) which is met in cash. Meeting VM obligations may impact a firm’s ability to realize an optimal return. Market participants may need to make an arrangement with their clearing firm or post additional securities and/or cash to mitigate VM-related cash movements.
Neither futures trading nor swaps trading are suitable for all investors, and each involves the risk of loss. Swaps trading should only be undertaken by investors who are Eligible Contract Participants (ECPs) within the meaning of Section 1a(18) of the Commodity Exchange Act. Futures and swaps each are leveraged investments 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 either a futures or swaps 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 traders cannot expect to profit on every trade.
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The information within this communication has been compiled by CME Group for general purposes only. CME Group assumes no responsibility for any errors or omissions. Additionally, all examples in this communication 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 superseded by official CME, CBOT, NYMEX and COMEX rules. Current rules should be consulted in all cases concerning contract specifications.
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