Cost Of Carry

Discussion in 'Index Futures' started by opmtrader, Nov 28, 2005.

  1. I have a simple question regarding "Cost of Carry" for ES futures. As a shorter term trader I have remained ignorant of these effects.

    What I want to know is what difference would there be between holding $60,000 worth of SPY stock and rolling $60,000 worth of ES futures (~ 1 contract) for a year. Lets assume the S&P 500 index went up 10%.

    Would both positions be worth $66,000 or would the futures position be less due to this cost of carry? My understanding is that the futures would be making less in some relation to the interest rate because of the inherent "free" leverage associated with it.

    Please help educate me on the matter as I am rather embarrassed of my ignorance on this topic. Thank you.
  2. Not an answer but volatility in markets is directly related to cost of carry. Just my opinon.

  3. cakulev


    Yes, you are correct.
    The futures return will be underperforming SPY by risk-free rate.
    If this was not the case you could put fully collateral in T-bills and outperform the market by 4%. You would be mega star in mutual fund industry!
  4. cakulev


    Nope, this is for option pricing, not futures.
  5. cakulev

    That was my exact plan !!!!!

    So is it exactly the T-Bill rate or what? There's got to be a way to use the free cash that futures allow to juice the returns of a buy and hold investment. Guess I need to be more creative.

    Would there be a better rate available than the one implicit in the futures? Correct me if I'm wrong but in the typical index futures contract, would your cost of carry relate directly to a three month interest rate? What if you committed to doing this for buy and hold futures for ten years and instead bought a ten year note from the gov't at a higher rate? Could this mitigate our costs or even beat the cost of carry on the shorter rate? What if you waited for a nice steep yield curve to do this?

    Any more discussion on this would be appreciated. Lets put our heads together and check out different scenarios where this might work.
  6. ig0r


    FV = S [1 + (I - D)]

    Where "S" is the S&P 500 Stock Index. The ticker symbol is SPX and/or INX on most good data feeds.

    Where "I" is the amount of Interest paid to your banker or broker to borrow the money to buy all of the stocks in the S&P 500 Index. The interest is calculated based on a percentage lending rate (R) from the current date (today) until the date that the S&P Futures Contract expires in March, June, September, or December.

    Where "D" is the amount of Dividends paid to you from the companies that you own in the S&P 500 Index that pay a dividend. The dividends are paid to you based on the record dates for any stock in the Index that is announced between the current date (today) and until the date that the S&P Futures Contract expires in March, June, September, or December. This dividend income is expressed as a percentage rate too.

    ie. You're paying a premium on cash for being able to carry the index components on margin (paying overnight FF rate, I believe, which you would not be able to get as a straight-up borrower in order to buy the actual index stock)
  7. cakulev


    As Igor said, dividends are also priced.

    The only scenario where make sense to hold index futures long term is on the short side. This way if the risk free interest is 4% you may want to buy T-bills and hence market have to grow more than 8% to start loosing money. If you believe that we are in major bull market, obviously this is not a viable strategy.

    Another way to utilize futures long term is to be long basket of stocks and using short futures + bonds as a hedge. This will essentially measure your alpha. Such a portfolio will have significantly smaller drawdowns and may be further leveraged.
  8. Thank you both for sharing.

    That short futures long T Bills sounds very compelling! I will have to remember that.

    I am really thinking, what if you waited for a historically high interest rate environment, with a steep yield curve, and set up a fund to do a long S&P + own 10 year note.

    What it would really be is a bet that interest rates would go down in the future and that the interest you would earn on your 10 year note would be higher than what you would be paying on all the 3 month interest of your rollovers in the lower rate environment.

    However it would be packaged as a "beat the S&P 500 by X%" with high odds. Might be more attractive from a marketing standpoint to your average retail client than a rate play.

    Agree on the marketing advantage? Does the mechanics of it work out? Thanks again for engaging in this discussion. Always interesting to me to try to figure out how to make money from a structural point of view.
  9. cakulev


    What you are talking about is structured index product. You can get very creative by combining futures, options, bonds, stocks.

    Here is an example from “Options as a Strategic Investment” by Lawrence G. McMillan

    Let's look at the structured index product to see how it might be designed and then how it might be sold to the public. Suppose that the designers believe there is demand for an index product that has these characteristics:
    1. This "index product" will be issued at a low price - say, 10 per share.

    2. The product will have it maturity date - say, seven years hence.

    3. The owner of these shares can redeem them at their maturity date the greater of either
    a) 10 per share or
    b) the percentage appreciation of' the S&P 500 index over that seven-year time period. That is, if the S&P doubles over the seven years, then the shares can be redeemed for- double their issue price, or 20

    In other words no risk of negative return (other than the bank going under :p ), while having the same return as the stock market if positive.

    How does the bank do it?

    Suppose that the bank wants to raise a pool of $1,000,000 from investors to create a structured product based on the appreciation of the S&P 500 index over the next seven years. The bank will use a part of that pool of money to buy U.S. zero- coupon bonds and will use the rest to buy call options on the S&P 500 index. Suppose that the U.S. government zero-coupon bonds are trading at 60 cents on the dollar. Such bonds would mature in seven years and pay the holder $1.00. Thus, the bank could take $600,000 and buy these bonds, knowing that in seven years, they would mature at a value of $1,000,000. The other $400,000 is spent to buy call options on the S&P 500 index. Thus, the investors would be made whole at the end of seven years even if the options that were bought expired worthless. This is why the bank can "guarantee" that investors will get their initial money back. Meanwhile, if the stock market advances, the $400,000 worth of call options will gain value and that money will be returned to the holders of the structured product as well.
  10. It does make sense to hold index futures long term because of their leverage. If let's say their leverage is 1:10 & given that historical average growth of s&p500 is 10% anually then the expected capital growth with futures would be 100% - 4% = 96% annually.
    #10     Nov 28, 2005