Statistical Arbitrage Strategies

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  • 1. ARBITRAGEIn arbitrage, combinations of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. An arbitrageur would typically buy a particular commodity at a lower price on one exchange and sell it on another where it fetchesthem a higher price. This creates a natural hedge and therefore the risk is low.
  • 2. Reasons for economic and commodity cycles and their relationship• Economic cycles refer to the cyclicality in an economy, as exhibited in an economic expansion and economic contraction and are generally divided into a recession, trough, expansion, and peak.
  • 3. Different reasons can be attributed to the formation of economic cycles:• Supply shocks due to a disturbance in production resulting from factors including natural disasters, climate changes, fluctuations in prices of raw material, technological advances, etc;• Demand variation resulting from economic (consumption) needs including monetary easing and exchange policy;• Demand from the private sector, including changes in consumer spending and preference of private investments
  • 4. Commodity arbitrage and spread trading• Step1: An investor buys a gold futures contract listed on Multi- Commodity Exchange (MCX), a national commodity exchange that offers investors access to various commodities. This contract is supposed to mature in 5JUNE 2012 and is available at Rs 28000 per 10 grams.• Step2: At the same the investor enters into a contract to sell gold in AUGUST on the National Commodity and Derivatives Exchange, another national commodity exchange in India. The price in this case for a similar quantity of gold is Rs 28050, which is higher that the amount on the MCX.• Step 3: On JUNE 1, it is seen that the rates for the gold contracts on both the exchanges have moved On the MCX the Gold JUNE contract became Rs 27,900, losing Rs 100 per 10 gms. And on the NCDEX, the price for the Gold AUGUST contract has gained by Rs 150 to become Rs 27,900• Step 4: Now the arbitrageur will sell the contract on MCX and lose Rs 100. At the same time he will liquidate the Gold AUGUST contract and gain Rs150. Totally, the investor will stand to gain Rs 50 from this transaction.
  • 5. Different strategies to trade commodity :• The Cash-and-Carry Arbitrage: This is the easiest form of arbitrage, where the investor has to buy the commodity in the spot market, and sell it in the futures market. This is largely successful in gold and silver, and is also popular among various agricultural commodities.• Calendar Spread: This is done between futures contracts. The investor buys the near month contract (ex: October gold) when prices are low, and sells in the forward month contract (December gold) when prices rise, or sell the positions in the near months, and purchase the forward months contracts.• This trading is popular in gold, copper, silver, crude oil, natural gas, chana, urad, jeera, and chilli. Spread between commodities with high correlation: Here, examples are gold and silver, gold and crude etc.• Inter-exchange arbitrage: This is popular among liquid commodities like gold and silver, where the arbitrage can take place between the Indian exchanges and the foreign exchanges, where contract specifications are similar.• Trading calls: Here, the trading is largely dependent on the direction of the trade. A good mix of commodities and disciplined trading will ensure that the investor makes money on the commodity markets.
  • 6. CRUDE SPREAD• US PX= $93• INDIA PX = 5050• USD/INR= 54.60• SO, US PX* USD/INR – INDIA PX = SPREAD• 93*54.60-5050=27.8• WE BUY 10LOTS IN INDIA(MCX) AND SELL 1 LOT IN US (NYMEX) TO MAKE A SPREAD.
  • 7. NYMEX CONTRACT DESCRIPTION• Light Sweet Crude Oil (Physical) futures are an outright crude oil contract between a buyer and seller. The contracts also serve as a key international pricing benchmark, and:• Offer excellent liquidity and price transparency• Provide the worlds most liquid forum for crude oil trading• Are the worlds largest-volume futures contract on a physical commodity• Serve the diverse needs of the physical market
  • 8. Things to know:• Unit of trading is 1,000 barrels• Delivery point is Cushing, Oklahoma, which is also accessible to the international spot markets via pipelines• Delivery provided for several grades of domestic and internationally traded foreign crudes• Six types of options: American style, calendar spread, crack spreads, average price, European style and daily
  • 9. Choice of Options Six different option types are available for light sweet crude oil: American, European, calendarspread, crack spread, average price and daily
  • 10. Options• . American options are different from European style options in that they can be exercised at any time, while the latter can only be exercised at expiration• Calendar spreads for light sweet crude involve two "legs" that expire on different dates: in a calendar spread call option, the spread option allows you to take a long position on (buy) the first expiring light sweet crude futures and take a short position in the second expiring light sweet crude futures in the spread• Crack spreads refer to a spread specific to the oil industry where the purchase of crude futures is offset by selling the refined products of crude, such as gasoline; this allows refiners to hedge against price fluctuations• Average Priced Options are over–the-counter (OTC) contracts with a payoff based on the average price of the underlying asset over a specified amount of time. The time frame, in which the average price is derived, is determined when the options contract is created. For example, settlement values are derived from the difference between the strike price and the average price of the underlying asset on the selected dates over the life of the options contract.
  • 11. ADR• An American depositary receipt (ADR) is a negotiable security that represents the underlying securities of a non- US company that trades in the US financial markets. Individual shares of the securities of the foreign company represented by an ADR are called American depositary shares (ADSs).• The stock of many non-US companies trades on US stock exchanges through the use of ADRs. ADRs are denominated, and pay dividends, in US dollars, and may be traded like shares of stock of US-domiciled companies.• The first ADR was introduced by J.P. Morgan in 1927 for the British retailer Selfridges. There are currently four major commercial banks that provide depositary bank services: BNY Mellon, J.P. Morgan, Citi, and Deutsche Bank.
  • 12. GDR• A global depository receipt or global depositary receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares.• Global depository receipts facilitate trade of shares, and are commonly used to invest in companies from developing or emerging markets.• Prices of global depositary receipt are often close to values of related shares, but they are traded and settled independently of the underlying share.
  • 13. HOW TO CALCULATE PREMIUMS AND DISCOUNT• FAIR PRICE = (LOCAL PX*RATIO)/CURRENCY• PREMIUM/DISCOUNT = (FAIR PX/ADR PX)-1• E.G. , LETS ASSUME THAT CHL , I.E.941 HKG CLOSED @77.75 IN THE LOCAL MKT (HONGKONG) AND HKG DOLLAR IS TRADING @ 7.7671 AND THE ADR(US) PX FOR CHL IS 48.57• SO, THE FAIR PX BECOMES 50.0508 AND THE DISCOUNT IS (50.0508/48.57)-1 = 3%• THIS MEANS THAT THE ADR PX IS TRADING @ 3% DISCOUNT FROM THE LOCAL MKT PX AND HENCE WE WILL BUY CHL IN US MKT.• SIMILARLY WE WILL SEE ALL THE STOCKS AND TRADE THEM AS PER THEIR PREMIUM OR DISCOUNT.• WE BUY THE STOCKS TRADING AT DISCOUNT AND SELL THE STOCKS TRADING AT PREMIUM
  • 14. DIFFERENT LEVELS TO INITIATE A TRADE• AGGRESSIVE- WHEN MARKETS ARE NOT MOVING MUCH AND IN A PARTICULAR RANGE WE TRADE ON THESE LEVELS• FUNDAMENTAL- WHEN THERE IS GOOD MOVE IN THE MARKETS AND STOCKS COME TO THERE FUNDAMENTAL LEVELS• PASSIVE – WE MARKETS OR INDIVIDUAL STOCKS MOVE TREMENDOUSLY DUE TO HIGH VOLATILITY OR SOME MAJOR NEWS WE TRADE AT THESE LEVELS.• THESE LEVELS ARE CALCULATED USING VARIOUS COMPLEX CALCULATIONS WHICH INCLUDE IMPLIED VOLATILTY, STANDARD DEVIATIONS, PROBABILITY AND STOCKS MOVEMENT FOR A PARTICULAR PERIOD .
  • 15. Major Factors That Affect Stock Price in stock market globally• Demand AND SUPPLY One of the major factors affecting stock price is demand and supply. The trend of the stock market trading directly affects the price. When people are buying more stocks, then the price of that particular stock increases. On the other hand if people are selling more stocks, then the price of that stock falls. So, you should be very careful when you decide to invest in the stock market.• Market Cap Never try to guess the worth of a company simply by comparing the price of the stock. You should always keep in mind that it is not the stock but the market capitalization of the company that determines the worth of the company. So market cap is another factor that affects stock price.• News When you get positive news about a company then it can increase the buying interest in the market. On the other hand, when there is a negative press release, it can ruin the prospect of a stock. In this case you should remember that news should not matter much but the overall performance of the company matters more. So, news is another factor affecting stock price.• Earning/Price Ratio Another important factor affecting stock price is the earning/price ratio. This gives you a fair idea of a company’s share price when it is compared to its earnings. The stock becomes undervalued if the price of the share is much lower than the earnings of a company. But if this is the case, then it has the potential to rise in the near future. The stock becomes overvalued if the price is much higher than the actual earning.