Index Arbitrage

In our previous post we discussed the idea of futures arbitrage, but we only scratch the surface of this investing strategy since we only focus on backwardation opportunities. Today we will go in-depth into what future index arbitrage really is and how it can be combine with the statistical arbitrage trading. However, before we can explain how to perform an index arbitrage technique we must first understand what indexes are.

What are Financial Indexes?

Indexes are financials products that either weight or collect the aggregate value or performance of a given asset class; for example equities or commodities. The main purpose of an index is to define and track the performance of different market sectors.

The most popular and better known of all indexes is the S&P500 (SPX, SPY, IVV, $.INX, SPTR, etc.) a market capitalization weighted index created by the Standard & Poor’s Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc. Over the years the S&P500 has become the market itself and the benchmark to beat for most portfolio managers.

Other than plain S&P futures contracts (S&P500 MINIs or Cash) the best financial exchange trading product to arbitrage is the SPDR ETF – $SPY.

What is Index Arbitrage?

As we all know now, arbitrage investing involve the simultaneous selling and buying of securities. Index arbitrage is no different here we need to buy and sell indexes, and indexes components at the same time. However instead of pairing indexes against each other like big money managers do (in order to hedge their investment portfolio).

“Just like the example I gave in my May Income Report, about being long the SPY and the TLT”

Here in the arbitrage portfolio community we do things differently, because we don’t arbitrage indexes against each other, since the arbitrage tactic I am about to share with you is based on the index fair value theory and the statistical arbitrage technique.

Index Fair Value Theory

Popularize by CNBC “Squawk Box” and created by professor Stoll. The index fair value of the S&P500 index is define by the spot value of the benchmark, times the interests pay on the margin account form the purchase of the indexes stocks, minus the dividends payment received, presented by the following equation:

Index Fair Value Formula:

FV = S (1 + r) – D         {FP – FV = Profits}

FV = Fair value
FP= future price
S = spot cash price
r = interest rate
D = dividends/distributions receive

• If you were to determent that the futures values are overprice: you will short the future contract and buy the index at the spot price.
• If you were to determent that the futures values are underprice: you will buy the future contract and sell the index at the spot price.

How to Index Arbitrage

Now that we understand all the concepts of what indexes are and how they can be arbitrage. We are ready to establish an index trade base on statistical arbitrage. Utilizing the pair trade structure of a long/short position, by knowing that the INX futures contracts are overprice relative to it fair value.

Index Arbitrage Steps:

1. Determent; if future prices are being misprice (over or under value relative to its fair price).
2. Simultaneously; short the future contract and with the proceeds buy the securities inside the index, by weight.
3. If the scenario is on reverse, you may buy the forward contract by selling the components inside the index.

Case Study Time

Develop an excel spreadsheet that can automatically calculate the fair value of an index in order to establish an arbitrage trade by determining the possible profitability of the position.

The Bottom Line

This investing strategy of index arbitrage via statistical analysis is very popular among hedge fund managers and is also known as portfolio insurance; and if carefully establish individual investors, arbitrageurs like us, can really profit from it.

Reference: The IB’s Futures Arbitrage Premium/Discount Index

Click Here To Download Your Free Index Arbitrage Trading and Fair Value Calculator