CAIA L2 - 6.4 - Relative Value Methods Flashcards
List
Frictions
that limits
arbitrage
6.4 - Relative Value Methods
- Regulatory
- implementation cost
- short limitations
- restrictions on leverage
6.4 - Relative Value Methods
List
4 steps
of pairs trading
6.4 - Relative Value Methods
- Identify candidate pairs. Either technical or fundamental analysis can be used to identify securities with significant historical relationships.
- Filter pairs for divergent spreads. Once relationships have been established, the universe of options needs to be filtered to find pairs where the current relationship is divergent from historical observations.
- Trade construction and sizing. Once divergent spreads are identified, long/short trades need to be constructed and sized to exploit the perceived mispricing.
- Exit strategy. Every strategy needs a preset sell discipline. What will the trader do if the divergence takes too long to converge? What will they do if the spread widens? They could add more to the position or exit the trade, depending on the depth of their conviction.
6.4 - Relative Value Methods
Define
cointegration
6.4 - Relative Value Methods
p’t and s’t are cointegrated if
the random variable u’t’ is stationary for a given value of ‘a’
ln(p’t’) – [ a × ln(s’t’) ] = u’t’
‘–
stationarity:
- relevant statistical properties (e.g., mean and standard deviation) do not change over time
Important to ensure that the relationship is static (constant Ut) before attempting to exploit spread divergence.
‘–
In general, pairs trading is a contrarian strategy
6.4 - Relative Value Methods
Identify
3 different commodity derivatives
calendar spreads
6.4 - Relative Value Methods
- bull calendar spread - long the near-term contract and short the longer-term contract. betting on markets widening for markets in backwardattion or narrowing for markets in contango
- bear calendar spread - short the near-term contract and long the longer-term contract, goal is spread narrowing for markets in backwardation and spread widening for markets in contango.
- synthetic weather derivative - bet on mild winter = short march natgas + long april natgas
6.4 - Relative Value Methods
List and explain
2 different
processing spreads
6.4 - Relative Value Methods
1. crack spread = crude oil vs heating oil + gasoline - purchases crude oil futures and sells heating oil and gasoline futures
A crack spread is expressed as a ratio of X:Y:Z in which X is the number of barrels of oil, Y is the number of barrels of gasoline, and Z is the number of barrels of heating oil. This ratio is subject to the constraint that X = Y + Z. Common ratios are 3:2:1, 5:3:2, and 2:1:1.
2. Crush spreads = soybean vs oil + meal - long position in soybean futures and a short position in soybean oil and soybean meal futures
Used by soybean producers to hedge the price of soybeans and two items derived from crushing soybeans (i.e., soybean oil and soybean meal)
6.4 - Relative Value Methods
List and explain
2 types
of commodity substitutes
in substitution spreads
t-stat formula
6.4 - Relative Value Methods
1. Production substitutes are present when a producer could produce two different commodities with the same natural resource. For example, farmers could use their land to grow corn or soybeans. Also, oil refineries could produce heating oil, gasoline, or jet fuel.
2. Consumption substitutes exist when consumers can switch between commodities when pricing dynamics change. For example, electric utilities can use different energy sources to produce electricity. When one becomes too expensive, they can switch to another, which will drive down prices in the former source and drive up prices in the new source.
t-stat’t’ = ln[ CP’HO,t’ / CP’NG,t’ ]
where:
CP’HO,t’ = closing price of heating oil at time t
CP’NG,t’ = the closing price of natural gas at time t
Long substitution spread = long numerator (short denominator)
100-dayStatistic = [ t-stat’t’ - (100-dayMAof t-stat ‘t’) ] / (100-day σ’t-stat’)
Used to determine if the spread has diverged enough to generate a potential arbitrafe profit
6.4 - Relative Value Methods
List and explain
2 types
of Intramarket Relative Value Strategies
6.4 - Relative Value Methods
1. Storage strategies will purchase a physical commodity on the spot market and then store it to satisfy the delivery requirements of a future-dated derivatives contract. This process can be both labor and capital intensive and involves leasing storage space. This can be profitable if the return on storage exceeds realized storage costs. This is equivalent to a calendar spread.
2. Transportation strategies involve buying a commodity and physically moving it from a relatively low-cost location (presumably due to oversupply) to a higher cost location (presumably due to local shortages). This strategy involves leasing services like tankers, bulk shipping, or pipelines.
6.4 - Relative Value Methods
Formula
covered interest rate parity
(pairs trading in rates from fixed income and currency markets)
6.4 - Relative Value Methods
(1+r’XXX’) × F’t’ / S’t0’ = (1+rYYY)
or
F’t’ = S’t0’ x (1+r’quote’)/(1+r’base’)
Dica: “base na base… Embaixo”
r’YYY’ = quote currency rate
r’XXX’ = base currency rate
EUR/USD = base/quote
F’t’ = forward rate
S’t0’ = spot rate
Example:
Base rate= 3.19%, the quote currency has a rate of 1.44%, the current spot rate between the two currencies is $1.18, and the futures rate is $1.16. Determine whether covered interest rate parity holds.
1.0319× ($1.16/$1.18) = 1.0144
or
1.18 x (1.0144/1.0319) = 1.16
Yes, CIRP holds
6.4 - Relative Value Methods
List
Risks
of Pairs Trading Strategies
6.4 - Relative Value Methods
1st + 2nd = Risks of Directional Fundamental Strategies
1. Noise traders’ risk is the potential for loss resulting from noise traders causing spreads to widen rather than converge. This risk is mostly idiosyncratic.
2. Fundamental risk The divergent spread between two securities could become permanent due to fundamental changes. For example, a new product could be developed, or a regulatory ruling could remove a key competitive protection. This risk is mostly idiosyncratic.
3. Corporate event risk Corporate events (i.e., mergers and spinoffs) can cause relationships between securities to change. Pairs traders in this area need to ensure diversification between multiple sets of pairs that involve different industries. This risk is a mix of systematic and idiosyncratic factors.
4. Synchronization risk occurs when convergence does not happen in a timely manner because market participants are slow to realize the divergence. It is not clear if this risk is always systematic or idiosyncratic. It depends on the circumstances.
5. Liquidity risk. Pairs trading candidates should be screened for sufficient liquidity. Bid-ask spreads and market impact are very important. Liquidity is nonconstant over time and could completely evaporate during periods of market distress. Because pairs traders are contrarian, one view sees them as providers of liquidity. This risk is mostly systematic.
6. Short-sale risk is the potential for loss due to a forced close to a short selling position. This could occur from a lender calling a margin loan, from a position crossing exit strategy parameters, or from a short squeeze. This risk is mostly idiosyncratic.
7. Model risk Because pairs trading is essentially a form of statistical arbitrage, it relies heavily on models. Parameters can be nonconstant, or the model could simply be wrong. Either way, this risk could present loss to a pairs trader. This risk cannot be diversified away, and it is also not really linked to the market.
8. Financing risk Pairs trades in fixed income and currency markets are highly reliant on leverage. This can present three risks asset-liability mismatch, the prime broker altering the lending terms in a disadvantageous way, and the financing agreement mandating a loan tenure that is not ideal for the strategy.
All are idiosyncratic EXCEPT
* Liquidity,
* Model.
* Corporate event = partially
6.4 - Relative Value Methods
How would one decide on the Entry and Exit points for pairs trading?
Both the entry point and the exit point are linked to the spread divergence.
Entry occurs when the spread diverges beyond a set threshold (often linked to historical standard deviations of the spread).
Exit could occur after achieving the desired convergence, after a set time period has passed with no real movement in the spread, or further divergence beyond a set target level takes place.
Pairs trading has been shown to be a potential source of superior returns. Traders still need to diversify with potentially 20 sets of pairs. One of the speculated return drivers is the liquidity differential between the two securities
LO 6.4.3
Describe carry trades
Borrowing at a relatively low interest rate, converting borrowed funds into another currency, investing in 2nd currency at a higher interest rate.
Harvest the rate differential between the two rates, assuming exchange rates remain constant.
Covered interest rate parity suggests that in informationally efficient markets, the carry trade should produce a return of zero - future exchange rates will be set to equalize interest rate differntials.
if inefficiency is present (covered interest rate parity does not hold), arbitrage carry trade profits are possible.
LO 6.4.5
3 Dimensions of commodity RV strategies
3 dimensions of commodity RV strategies:
1. Location. The same commodity may have different prices based on its location.
2. Correlation. The relative prices between two commodities may diverge from historical norms.
3. Time. Commodity prices may diverge based on time of delivery.
LO 6.4.4
REAL ASSETS
Differentiate between Contango & Backwardation
Reading 3.2: Commodities
The term structure of futures prices (or simply, the forward curve) is the relationship between the futures price and the maturity of the contract:
- Contango. This refers to a price pattern where the futures price is above the spot price and converges to that price from above over time. Contango markets have an upward sloping forward curve.
- Backwardation. This refers to instances in which the futures price is less than the current spot price. In these cases, the forward curve will be downward sloping, indicating that the futures price is lower for longer-term contracts.
4 possible forward market return structures
- Backwardation. The current forward price is less than the current spot price.
- Normal backwardation. The current forward price is less than the expected future spot price.
- Contango. The current forward price is greater than the current spot price.
- Normal contango. The current forward price is greater than the expected future spot price.
