Discussion in 'Index Futures' started by ssternlight, Aug 16, 2005.

  1. Does anyone know how IWM is priced relative to the ER2? It looks like something close to 1:10 but it is not exactly so... I'm trying to understand it for hedging purposes.

    Thanks to anyone who can explain...
  2. First of all, the question, as you asked it, has no answer. No fixed relationship exists between the two prices. Numerous differences between the two trading vehicles make it inevitable that they will have slightly different prices, although a ratio of 10:1 is a good approximation.

    If you trade the ER2, you are making a bet as to the future value of the Russell 2000 Index. If you trade the IWM, you are not making the same bet. You are instead buying equity shares in a portfolio of stocks, which are constructed and continually adjusted and managed, in an effort to match, as closely as possible, the performance of one-tenth of the index value represented by ER2. But there will always be "tracking error", in that the performance of the portfolio will always differ somewhat from the trajectory of the index. The portfolio, for example, suffers from transaction costs, which do not affect the course of the index. The portfolio managers, in order to limit transaction costs, do not construct the portfolio to be an exact match for the index. Some of the 2000 stocks are omitted entirely, and the rest are not included at the exact same proportion as in the index. It's an art, not a science. So if you trade IWM, you are betting on BOTH the course of the Russell 2000 Index, AND on the degree of success of the IWM portfolio managers in tracking the index.

    Another difference between the two vehicles is in their capital requirements. If you trade the IWM, you must commit funds to meet margin requirements for equities, but if you trade ER2, your margin requirements will be far lower. The extra margin required for IWM, but not for ER2, can therefore be invested in an interest-bearing account, when you trade ER2, but not IWM; and this tends to make ER2 compensate, by trading at a higher price. But also, if you are long IWM, you can earn dividends, but not with ER2; and this factor tends to make ER2 compensate by trading at a lower price. The amount of time left before the ER2 contract expires also shapes the amount by which the contract's price will differ from IWM as a result of interest and dividends. IWM also has higher transaction costs, less liquidity, and less favorable tax treatment than ER2, which help accentuate short-term price differences between the two vehicles.

    So don't even expect the two prices to have an exact fixed relationship.
  3. hi Jim

    whats your background to be able to explain all
    you did so well ?

  4. Well, thanks for the compliment, Setharb, but I don't have any finance background, I'm just a guy who pays attention. You can learn an awful lot just by paying attention. Most people don't pay attention.