CARR FUTURES

GALEN BURGHARDT JAY COLLINS GEORGE PANOS

JANUARY 20, 2004

E-miniTM futures can reduce the cost of trading equities

www.carrfutures.com

CARR FUTURES

S&P Trading Floor (312) 441-4567 Galen Burghardt (312) 762-1140 Jay Collins (312) 762-1755 George Panos (312) 762-1143

research note note

Under fairly reasonable cost assumptions, someone who trades 500,000 QQQ shares a month could easily save $225,000 a year in transactions costs using E-mini futures. E-mini stock index futures provide institutional traders with a highly competitive alternative to exchange-traded funds (ETFs) for trading broad based stock indexes. For example, a single NASDAQ 100 E-mini futures contract is the equivalent of 800 QQQ shares. And, under very reasonable cost assumptions, the total round-turn cost of trading a single NASDAQ 100 E-mini contract would be $18. In contrast, if the total round-turn cost of trading QQQ shares were $.06 per share, the cost of trading 800 shares would be $48. For a high volume trader, the difference can look like real money. The purpose of this brief note is to outline the key relationships between E-mini futures and their corresponding stock price indexes and ETF shares. In particular, we cover what you need to know about E-mini and ETF equivalents Market size Costs of trading Futures and ETF pricing Tracking and tracking error Trading hours Capital requirements for futures Electronic trading and a few related practical considerations.
Exhibit 1 E-mini futures and their ETF equivalents (closing prices as of 12/18/03)
Futures detail
E-mini contract NASDAQ 100 S&P 500 Russell 2000 S&P Midcap 400 price 1435.50 1066.90 553.65 575.00 multiplier $20 $50 $100 $100 portfolio equivalent value $28,710 $53,345 $55,365 $57,500

E-mini and ETF equivalents

Exhibit 1 lists the five E-mini futures contracts and their ETF share equivalents measured in portfolio equivalent values. While the futures contracts themselves have no liquidating or cashing out value, they produce gains and losses like those on actual stock portfolios. For example, gains and losses on a NASDAQ 100 futures contract are set equal to $20 (the multiplier) times changes in the index futures price. Thus, a single NASDAQ100 e-mini contract had a portfolio equivalent value of $28,710 [ = 1,435.50 x $20 ] at the close of trading on December 18th, 2003. This is roughly the same as the portfolio value of 800 QQQ shares, which was $28,552 [ = 800 x $35.69 ] at the close of trading. The S&P500 and the Russell 2000 E-mini contracts are the equivalent of about 500 of their corresponding ETF shares, while the S&P Midcap400 is the trading equivalent of about 550 ETF shares.

Market size
E-minis represent the larger market if the volume of trading in each market is translated into its portfolio equivalent value. Exhibit 2 shows average daily trading volume in E-minis and ETFs for November 2003. Futures volume is measured in contracts, while ETF volume is measured in shares. For example, the E-mini NASDAQ traded

ETF detail
minimum tick 0.50 0.25 0.10 0.10 minimum tick value $10.00 $12.50 $10.00 $10.00 symbol QQQ SPY IWM MDY equivalent shares 800 500 500 550 price per share $35.69 $107.38 $110.69 $105.55 combined share value $28,552 $53,690 $55,345 $58,053

The reader is advised that futures and options are speculative products and the risk of loss can be substantial. Futures spreads are not necessarily less risky than short or long futures positions. Consequently, only risk capital should be used to trade futures. The information contained herein is based on sources that we believe to be reliable, but we do not represent that it is accurate or complete. Nothing contained herein should be considered as an offer to sell or a solicitation of an offer to buy any financial instruments discussed herein. All references to prices and yields are subject to change without notice. Past results are no indication of future performance. Any opinions expressed herein are solely those of the author. As such, they may differ in material respects from those of, or expressed or published by or on behalf of, Carr Futures or its officers, directors, employees or affiliates. Carr Futures, 2004

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Exhibit 2 Average daily trading volume (November 2003)
Futures trading Index contracts per day 276,518 579,077 24,272 7,591 portfolio equivalent value* ($billions) $7.9 $31.5 $1.3 $0.4 ETF trading shares per day 79,015,078 33,232,740 3,409,073 1,055,799 portfolio equivalent value* ($billions) $2.8 $3.6 $0.4 $0.1 Ratio of futures to ETF volume (pev) 2.8 8.8 3.3 4.0

NASDAQ100 S&P500 Russell 2000 S&P Midcap 400

* Average November daily volume valued at 12/18/03 closing prices

an average of 276,518 contracts a day in November, while the QQQs traded an average of 79,015,078 shares a day. From this standpoint, it is apparent that the ETF market handles more units than does the futures market. If we translate the units traded into their portfolio equivalent values, however, the notional value of trading in E-minis is substantially larger. If we use the portfolio values shown in Exhibit 1, we find that a daily volume of 276,518 NASDAQ100 E-minis translates into a portfolio value of $7.9 billion, while 79,015,078 QQQ shares translates into a portfolio value of only $2.8 billion. By this standard, the E-mini futures market was 2.8 times the size of its corresponding ETF market. The average value of trading in S&P500 E-minis would have been $31.5 billion a day, which was 8.8 times greater than the $3.6 billion a day traded in SPYDR ETFs.

Costs of trading
The cost of trading a futures contract comprises two parts the value of the bid/ask spread and round-turn brokerage commissions. Exhibit 3 provides reasonable estimates of what the costs of trading E-mini futures would be. Cost assumptions In all five cases, the bid/ask spread in futures typically trades at the minimum value set by exchange rules. For example, the minimum tick (the smallest amount by which the
Exhibit 3 Costs of trading e-minis
Contract NASDAQ 100 S&P 500 Russell 2000 S&P Midcap 400 typical bid/ask* $10.00 $12.50 $10.00 $10.00 round-turn brokerage $8.00 $8.00 $8.00 $8.00 total roundturn cost $18.00 $20.50 $18.00 $18.00 ETF shares per contract 800 500 500 500 per share equivalent $0.0225 $0.0410 $0.0360 $0.0360

futures price is allowed to change) is 0.50 index points for the NASDAQ100 contract. Given a mulitplier of $20 per index point, the value of the typical bid/ask spread would be $10. For the S&P500, the typical bid/ask spread would be $12.50. Brokerage commissions will vary from broker to broker and client to client, but a safe assumption for these purposes would be $4 per side (i.e., to buy or sell a single contract), which would be $8 for a round turn. Given these assumptions, then, the total round turn cost of trading a NASDAQ100 E-mini contract would be $18, while the total round turn cost of trading an S&P500 Emini contract would be $20.50. Our experience in these markets gives us confidence in the typical bid/ask spreads that we show in Exhibit 2. This is, however, an empirical judgement on our part that you can check for yourself on Bloomberg. For example, NQH4 <Index> CT <Go> will show you the current volume and open interest of the March 2004 NASDAQ100 E-mini contract. From there, QRM <Go> will take you to a time and sales report that will show the bid and offer and size on both sides of the market throughout the day. Addendums 1 and 2 show snapshots of the books and time-and-sales reports for both the E-mini S&P500 and NASDAQ100 contracts about one hour after the spot open and five minutes after the spot close on January 20, 2003. Potential cost savings The right-most column of Exhibit 3 translates the round-turn cost of trading an E-mini futures contract into the roundturn cost per share of the equivalent ETF. For example, the $18 total round-turn cost of trading an E-mini NASDAQ100 contract would be the same as $.0225 per QQQ share. The cost of trading an E-mini S&P500 futures contract would be the same as $.0410 per SPYDR share. How much you stand to save by trading E-mini futures depends entirely, then, on how much it costs you to trade ETF shares. For example, if your total round-turn cost of trading QQQs is $.06 per share, then the cost of trading a

* Source: Carr Futures.

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single E-mini futures contract would be $30 less than the cost of trading 800 QQQ shares. If you trade 500,000 QQQ shares a month, then your monthly savings would be $18,750, or $225,000 a year. Exhibit 4 shows what your monthly savings would be for various trading volume and ETF cost assumptions.
Exhibit 4 What you could save each month using NASDAQ100 e-mini futures instead of QQQ ETFs
QQQ shares traded per month 100,000 500,000 1,000,000 5,000,000

19, 2004. Using the expected dividend assumptions shown in Exhibit 5, we find that the fair value of the S&P500 futures price on December 18th was 1087.84 [ = 1089.18 ( 1 + .0171 ( 92/360)) 4.60 ]. Futures closed at 1088.50, which was 0.66 index points above fair value. ETF pricing In contrast, the practice with ETFs is to accumulate dividends paid on the underlying over the course of a quarter and then to distribute them at quarter end. As a result, the relationship between ETF share prices and the value of underlying stocks is: ETF fair value = Spot index (normalized) + Accrued dividends where accrued dividends represents the value of dividends paid on underlying stocks but not yet paid out to ETF holders. The difference between these relationships is illustrated in Exhibits 6 and 7. For example, in the upper panel of Exhibit 6, we show the percent difference between the unadjusted lead S&P500 futures price and the S&P500 index. During the early part of the history, when financing interest
Exhibit 6 Daily % difference between S&P500 lead futures & cash index contract August 11, 2000 - November 10, 2003
3% 2% 1% 0% -1% -2% -3% 2000
unadjusted

Round-turn trading cost per QQQ share

$0.04 $1,750 $8,750 $17,500 $87,500 $0.06 $3,750 $18,750 $37,500 $187,500 $0.08 $5,750 $28,750 $57,500 $287,500 $0.10 $7,750 $38,750 $77,500 $387,500

Futures and ETF pricing

The relationships between futures prices, ETF share prices and their underlying index are driven by slightly different forces. Futures pricing For example, the zero arbitrage relationship between the futures price and the underlying spot index is: Futures fair value = Spot index [ 1 + Financing rate (Days/360) ] Expected dividends where the financing rate is the relevant cost of financing a position in the underlying stocks, Days is the number of days from now until futures expiration, and expected dividends, strictly speaking, represents the forward value of all dividends expected to be paid on the underlying index between now and futures expiration. Exhibit 5 compares the fair and market values of the March 04 futures prices for the five different contracts. In all cases, we use a term financing rate of 1.17% and a financing period of 92 days from December 18, 2003 to March
Exhibit 5 Futures fair values (12/18/03)
March 2004 futures
Index NASDAQ 100 S&P500 Russell 2000 S&P Midcap 400 spot 1431.31 1089.18 546.90 568.56 BBG Symbol dividend LIBOR NQ ES RR FA 0.48 4.60 1.49 1.56 1.17% 1.17% 1.17% 1.17% fair 1435.11 1087.84 547.05 568.70 market 1433.50 1088.50 546.00 568.00 Rich/ cheap -1.61 0.66 -1.05 -0.70

2001

2002

2003

3% 2% 1% 0% -1% -2%

dividend & interest adjusted

-3% 2000

2001

2002

2003

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rates were higher than dividend yields, one can see the saw tooth pattern that resulted from the relatively higher futures price converging down each quarter to the relatively lower spot index. More recently, because financing rates have been about the same as dividend yields, there has been no regular, obvious convergence. The upper panel of Exhibit 7 shows the percent difference between the unadjusted SPYDR price and the S&P500 index. Throughout, one can see the saw toothed pattern that results from the accrual of dividends as each quarter progresses. In the bottom panels of Exhibits 6 and 7, we show how the adjusted futures and ETF price series compare to the S&P500 index. In the case of futures, we have adjusted both for financing and expected dividends. In the case of ETFs, we have adjusted for accrued dividends. The resulting percent differences are free of any patterns.
Exhibit 7 Daily % difference between S&P500 ETF & cash index August 11, 2000 - November 10, 2003
3% 2% 1% 0% -1% -2% -3% 2000 3% 2% 1% 0% -1% -2% -3% 2000 dividend adjusted unadjusted

equivalent financial positions. For example, one can create synthetic stock by combining futures with a term cash instrument whose maturity matches the time to expiration of the futures contract and whose value matches the market value of an actual stock portfolio. And, as a result, the equivalent returns would be Futures return + money market return = Stock return + dividends where futures return is the percent change in the futures price, money market return is the actual return to a term money market instrument, stock return is the percent change in the stock price, and dividends are realized dividends. As a rule, when money market rates are higher than dividend yields, futures price returns will be lower than stock price returns.

Tracking and tracking error

In practice, both E-mini futures prices and ETF prices tend to trade at or very near fair value most of the time. As a result, both instruments provide institutional traders with effective ways of trading the general levels of stock prices. To illustrate this, we compare total S&P500 futures returns and total SPYDR ETF returns with total returns to the underlying stock portfolios for trading horizons of one day, one week, and one month. The futures/spot comparisons are shown in Exhibit 8. ETF/spot comparisons are shown in Exhibit 9. In both cases, the fit was extremely good and got better as one lengthens the trading horizon. For example, the R2 values for daily returns are 93.1% for futures and 92.8% for ETFs. For monthly returns, the R2 values are 97.5% for futures and 98.5% for ETFs. R-squared values as high as these suggest that tracking error with either instrument would be very low. For example, the standard deviation of the monthly S&P returns in our data set was 2.48%. The standard deviation of the difference between S&P spot returns and S&P futures returns was .19%, while the standard deviation of the difference between S&P spot returns and SPYDR returns was .14%.

2001

2002

2003

Trading hours, timing mismatches, stale prices, and price discovery

E-mini futures and ETFs trade on schedules that do not correspond exactly to normal trading hours for their underlying stocks. E-minis, for example, trade almost 24 hours a day. The trading day begins at 4:30 p.m. New York time on Monday through Thursday (6:30 pm. New York time on Sunday) and closes at 4:15 p.m. New York time the following business day. The ETF exchange trading day begins at 9:30 a.m. New York and closes at 4:15 p.m. New York time. ETFs can be traded during other times via Instinet and other electronic exchanges.

2001

2002

2003

Comparing returns Because of the way futures and ETFs are priced, any comparison of returns to the two instruments should reflect

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Exhibit 8 S&P500 futures v cash index returns January 3, 2000 - December 31, 2003
10%

Exhibit 9 S&P500 ETF v cash index returns January 3, 2000 - December 31, 2003
10%

Daily

Daily

5%

5%

(R^2 = 92.8%)

Futures returns

(R^2 = 93.1%) 0%

Futures returns
0% 5% 10%

0%

-5%

-5%

-10% -10% -5%

-10% -10% -5% 0% 5% 10%

Cash index returns

Cash index returns

10%

Weekly

10%

Weekly

5%

(R^2 = 97.3%)

5%

(R^2 = 98.9%)

Futures returns

Futures returns

0%

0%

-5%

-5%

-10% -10% -5% 0% 5% 10%

-10% -10% -5% 0% 5% 10%

Cash index returns

Cash index returns

10%

Monthly

Monthly
10%

5%

(R^2 = 97.5%)

5%

(R^2 = 98.5%)

Futures returns

Futures returns

0%

0%

-5%

-5%

-10% -10% -5% 0% 5% 10%

-10% -10% -5% 0% 5% 10%

Cash index returns

Cash index returns

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One valuable aspect of E-mini and ETF prices is that the market can trade them at prices that reflect what the value of the underlying index would be if all of the stocks in the index were to trade at the same time at market prices. Stock price indexes tend to lag the actual market because they are calculated using stale prices that is, prices at which the stocks last traded rather than their current market prices. As a result, the 4:00 p.m. (New York time) values of the NASDAQ100 or the S&P500 are not entirely accurate representations of the values of their component stocks. The 4:15 p.m. (New York time) close for E-minis and ETFs also allows for some additional price discovery following the exchange closing of the component stocks. Much of what appears to be tracking noise in Exhibits 8 and 9 is really nothing more than the result of the market responding to events during the 15 minutes between the close of the markets for individual stocks and the markets for E-minis and ETFs. An extreme example stands out in Exhibits 6 and 7 where one can see both the E-mini and ETF prices trading at what appears to be a discount of almost 2% to the value of the underlying index. This occurred on December 8, 2000 and reflected the effect of the Florida Supreme Court decision regarding the 2000 presidential election recount.
Exhibit 10 Minimum capital requirements for E-minis (required margins or performance bonds as of December 17, 2003)
Outright market NASDAQ100 S&P500 Russell 2000 S&P Midcap 400 Spread market (ratio in parens) S&P vs. Nasdaq (1:2) S&P vs. Midcap (1:1) Midcap vs. Nasdaq (2:3) Russell vs. Nasdaq (1:2) Russell vs. S&P (1:1) Russell vs. Midcap (1:1)

Required margins
initial $4,000 $3,750 $3,500 $3,500 maintenance $3,200 $3,000 $2,800 $2,800

Required margins
initial $1,350 $650 $1,325 $1,150 $1,000 $625 maintenance $1,080 $520 $1,060 $920 $800 $500

In practice, institutional traders can trade electronically in either of two ways. First, a trading terminal can be placed on the traders desk. This gives the trader complete control over order entry and order management. Second, the trader can call in orders to a futures broker, who in turn will fill the order on the electronic platform.

Minimum capital requirements for futures

Because futures margins, otherwise known as performance bonds, are geared chiefly to protecting both sides of a trade against the others trading losses, futures make comparatively efficient use of your capital. Examples of the minimum margins required by the exchanges are shown in Exhibit 10. The upper panel shows the minimum requirements for outright long or short positions. The lower panel shows margins for typical spread positions. It is worth noting two things about these margins. First, they are the minimum requirements set by exchanges. The actual amounts required can be more than these minimums and will vary from broker to broker and client to client. Second, exchange margins are reviewed frequently and are changed with relative regularity to reflect changes in market volatility.

Practical considerations
Perhaps the most obvious practical considerations for those who trade E-minis and ETFs are those related to accounting, regulation, and taxes. Futures are futures, while ETFs are mutual funds. For certain users, the differences in the way the two are treated can be extremely important. With futures, for example, all gains and losses are realized and are settled in cash daily. With mutual funds, gains and losses will be a mix of realized (associated with changes in the composition of the fund) and unrealized. For those who want to use these instruments for longer term trades or investments, the quarterly expiration associated with futures means that positions must be rolled each quarter. And, even though the costs of rolling futures positions are lower typically than the costs of outright buys and sells, they will, over time, add up. On the other hand, the holders of ETFs (i.e., those who are long) pay a service fee to the sponsor of the fund that ranges between 10 and 20 basis points per year, depending on the fund.

Electronic trading
By definition, all E-mini futures are traded electronically (hence, the E) through futures brokers with access to GLOBEX (the Chicago Mercantile Exchanges platform). The electronic futures platforms have performed extremely well and have been largely responsible for the depth and liquidity of these markets and the speed with which large orders can be filled.

For further information

For further information about trading E-mini futures, please contact any of the authors of this note or your account executive at Carr Futures.

E-miniTM and GLOBEX are registered trademarks of the Chicago Mercantile Exchange. All E-minis are products of the Chicago Mercantile Exchange.

CARR FUTURES

Addendum 1
S&P500 E-mini as of January 20, 2004

The book (about one hour after spot open)

Time-and-sales (about one hour after spot open)

The book (about five minutes after spot close)

Time-and-sales (about five minutes after spot close)

CARR FUTURES

Addendum 2
NASDAQ100 E-mini as of January 20, 2004

The book (about one hour after spot open)

Time-and-sales (about one hour after spot open)

The book (about five minutes after spot close)

Time-and-sales (about five minutes after spot close)

CARR FUTURES