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Hedging fx spot with fx futures?
- Thread starter schoe
- Start date
How long do you plan to hold your hedged position? Just a few minutes around the dealer's daily swap time... a day... over the weekend... weeks or months?
True, futures can be a nearly perfect hedge for spot. However, as I'm sure you know, the interest rate differential (which is what the daily swap rate reflects) is already built into the futures price. Specifically, into its spread over/under spot price, which must gradually converge to 0 at futures contract expiration.
So, to be able to earn risk-free, interest rates-driven profits on that hedge strategy, you'll need to overcome 3 "negative edges":
1) bid / ask spread, on each leg of your hedge
2) commissions on at least the futures leg of your hedge, and possibly on the spot leg as well
Nothing new or surprising so far... pretty much every hedge in the world, involving two or more legs, would obviously involve those two friction factors.
3) by far the biggest one of all: dealer's implied swap rate adjustment vs. real short-term rates. Or rate markup on the debit and markdown on the credit side of spot, for those dealers who don't use swaps. By contrast, futures spread over/under spot has no such implied dealer's drag, creating that negative edge over time.
True, futures can be a nearly perfect hedge for spot. However, as I'm sure you know, the interest rate differential (which is what the daily swap rate reflects) is already built into the futures price. Specifically, into its spread over/under spot price, which must gradually converge to 0 at futures contract expiration.
So, to be able to earn risk-free, interest rates-driven profits on that hedge strategy, you'll need to overcome 3 "negative edges":
1) bid / ask spread, on each leg of your hedge
2) commissions on at least the futures leg of your hedge, and possibly on the spot leg as well
Nothing new or surprising so far... pretty much every hedge in the world, involving two or more legs, would obviously involve those two friction factors.
3) by far the biggest one of all: dealer's implied swap rate adjustment vs. real short-term rates. Or rate markup on the debit and markdown on the credit side of spot, for those dealers who don't use swaps. By contrast, futures spread over/under spot has no such implied dealer's drag, creating that negative edge over time.
Thanks for the reply Apex.
I would hold the trades indefinitely for weeks at a time otherwise it is not worth doing due to the spread on the spot side of the trade.
I do not understand how the interest is already built into the futures price and how this affects the hedge, can you explain that to me in simple terms and if possible give me an example of how it works in practice.
Many thanks.
I would hold the trades indefinitely for weeks at a time otherwise it is not worth doing due to the spread on the spot side of the trade.
I do not understand how the interest is already built into the futures price and how this affects the hedge, can you explain that to me in simple terms and if possible give me an example of how it works in practice.
Many thanks.
Indefinitely for weeks at a time... OK, that's what I was worried about. You may nicely neutralize negative friction factors 1 and 2, but, as a retail, non-institutional player, you get hit hard by #3. Yep, the world ain't fair, after all...
In a nutshell, any gains you'll make on the spot side (retail-priced, in terms of implied interest rates) will be more than offset by the gradual loss / convergence, realized on the futures side (wholesale, or fair-priced, again, strictly in terms of implied interest rates), as the futures price converges to the spot price, the closer you get to expiration. Have you had a chance to go over the discussion in this recent thread?
http://www.elitetrader.com/vb/showthread.php?s=&threadid=66505
What it does is compare two ways of putting on a long USD / short JPY carry trade, via spot or futures. Something closely related to your quest for risk-free arbitrage. Futures turn out to be more cost-effective over the long term, precisely because of negative friction factor #3 -- that dealer's adjustments to the short-term rates. (In that case, explicit, not implied, adjustments... the way it should be done.) See if that discussion helps you better understand the practical flaw in your proposed risk-free arb, then feel free to ask anything again, if need be.
Incidentally, which currency pair(s) did you have in mind?
In a nutshell, any gains you'll make on the spot side (retail-priced, in terms of implied interest rates) will be more than offset by the gradual loss / convergence, realized on the futures side (wholesale, or fair-priced, again, strictly in terms of implied interest rates), as the futures price converges to the spot price, the closer you get to expiration. Have you had a chance to go over the discussion in this recent thread?
http://www.elitetrader.com/vb/showthread.php?s=&threadid=66505
What it does is compare two ways of putting on a long USD / short JPY carry trade, via spot or futures. Something closely related to your quest for risk-free arbitrage. Futures turn out to be more cost-effective over the long term, precisely because of negative friction factor #3 -- that dealer's adjustments to the short-term rates. (In that case, explicit, not implied, adjustments... the way it should be done.) See if that discussion helps you better understand the practical flaw in your proposed risk-free arb, then feel free to ask anything again, if need be.
Incidentally, which currency pair(s) did you have in mind?
Many thanks again for the comprehensive reply! I was going to trade GBP/CHF and am not surprised it is not as easy as I thought it was going to me to collect the interest no such thing as a free lunch in trading it would seem.
I have thought about trying to open an interest free account but i've been told that they quickly recognise this and close it down on you, although not sure how much truth there is in that.
I have just sold my house and was going to invest it in this risk free way but now may have to look for another low risk strategy!
Hmm hopes dashed again!
Thanks again.
I have thought about trying to open an interest free account but i've been told that they quickly recognise this and close it down on you, although not sure how much truth there is in that.
I have just sold my house and was going to invest it in this risk free way but now may have to look for another low risk strategy!
Hmm hopes dashed again!
Thanks again.
Quote from schoe:
Many thanks again for the comprehensive reply! I was going to trade GBP/CHF and am not surprised it is not as easy as I thought it was going to me to collect the interest no such thing as a free lunch in trading it would seem.
I have thought about trying to open an interest free account but i've been told that they quickly recognise this and close it down on you, although not sure how much truth there is in that.
I have just sold my house and was going to invest it in this risk free way but now may have to look for another low risk strategy!
Hmm hopes dashed again!
Thanks again.
Flush with the cash from selling the house, eh? If you're looking for a low-risk strategy, one suggestion would be to look up the current and 2 previous Cash & Carry journals by ElectricSavant, in the Journals forum. Lots of excellent, hands-on content there on generating significant interest stream with hedged currency baskets.
As far as this spot-futures interest rate arb... hmm... dunno 'bout hopes dashed, but now you've actually got me thinking deeper about some of the practical issues / barriers involved.
When I mentioned "a few minutes around the daily swap time"... as it happens, doing it that way completely eliminates the biggest negative factor, #3. Just kills it, period. Of course, we've still got the two spreads and at least one set of commissions to overcome. Wonder if that can be pulled off, after all. It's already past my bedtime... will have to think about this later and maybe crunch some numbers. Will post anything I come up with, although, honestly, don't know if this path is going anywhere.
Thanks Apex. The opening and closing idea definitely wouldn't work as there is no way you can overcome the spread, on the interest payment alone it takes about a week of holding the position to move into profit.
Samson are you talking from experience if so can you pm me the name of the Broker you use?
I have read the cash and carry threads and it is a very ingenius system devised by Michael and it may well work however I see he himself has just stopped trading it due to some problems which does not inspire confidence in the method i'm afraid.
Anybody else have any suggestions/ideas.
Samson are you talking from experience if so can you pm me the name of the Broker you use?
I have read the cash and carry threads and it is a very ingenius system devised by Michael and it may well work however I see he himself has just stopped trading it due to some problems which does not inspire confidence in the method i'm afraid.
Anybody else have any suggestions/ideas.
Quote from schoe:
Thanks Apex. The opening and closing idea definitely wouldn't work as there is no way you can overcome the spread, on the interest payment alone it takes about a week of holding the position to move into profit.
What values are you using for the spread and interest, to get "about a week"? I am not seeing that.
In general, the GBP/CHF cross is burdened with a high spread, say, 5-6 pips (0.0221% - 0.0265% per RT), relative to its positive interest carry, currently 2.90% APR at best (0.0079% daily swap rate), before applying leverage. There are better crosses to play for the interest arb game, all involving JPY.
Hi Apex. I must admit I haven't studied it but I was referring to if you had to pay twice the spread on GBP/CHF which was 8 on the platform I was using. ( I say you have to pay it twice if you are hedging with an interest free account)
It may be different with other currencies with narrower spreads and if you only collect the interest with no hedging?
When I get time I will look into it or maybe somebody else can tell us if its possible?
Regards Schoe.
It may be different with other currencies with narrower spreads and if you only collect the interest with no hedging?
When I get time I will look into it or maybe somebody else can tell us if its possible?
Regards Schoe.