RESEARCH AND product DEVELOPMENT

Improving Equity Index Futures

Tracking and Performance
with Interest Rate Futures

By Richard Co, Research and Product Development

May 2008
cmegroup.com

The drop in interest rates – a total of 147 bps from the beginning of the
This article discusses month to the end of the month – drove a wedge of 27 bps per annum
how to maximize returns between the total return on the synthetic portfolio and the total return
on the cash portfolio. This differential manifests as an unexpectedly rapid
on an equity index futures erosion in the cash-futures price premium.

strategy by using interest EXHIBIT 1:

S&P 500 Index: CME Group futures vs. cash, Jan 08.
rate futures to reduce
Price Total
tracking errors from Dec 31 07 Jan 31 08 Return Return1
S&P 500
short-rate movements. … Futures 1477.20 1379.60 -6.61% -6.27%
… Cash Index 1468.36 1378.55 -6.12% -6.00%
… Futures Premium 8.84 1.05
Finance Rate 4.648% 3.174%
(See footnote 1 for details of Total Return calculation.)
The valuation of any equity index futures contract requires consideration
of the interest rate environment. Portfolio managers who neglect this may
Suppose the cash component of the synthetic futures structure had been
be met with unwelcome tracking errors, which arise naturally from the
invested so as to earn a suitable money market interest rate over the term
interaction of short-term interest rate movements with daily marks-to-
until futures expiration. The drop in interest rates would have generated
market on futures.
gains which, in turn, would have closed the performance gap between the
One can bring these tracking errors under control through judicious use of synthetic futures portfolio and the cash portfolio.
interest rate futures. This document reviews various strategies for doing so.
Combining a long position in equity index futures with a money market
The discussion is organized into five parts: Part one outlines how interest
instrument paying the overnight interest rate effectively amounts to the
rate movements generate tracking errors that may undermine equity
following:
futures performance. Parts two and three explore how CME Group 30-day
Fed Funds rate (FF) futures and Eurodollar (ED) futures, respectively,
Long Equity Index Futures
may be used to control this source of risk or, alternatively, to exploit it as a
• Receive performance of Index
potential source of incremental return. Part four considers combinations
• Pay fixed interest rate on notional value
of FF and ED futures. Part five measures the added transaction costs that
a user would incur by combining interest rate futures with a core equity
Money Market Instrument
index futures position.
• Receive overnight rate on notional value
• Commit notional value in cash
Part I: Tracking Errors Due to Short Rate Movements
Consider January 2008. Countering a sharp deterioration in credit market
This set up makes the synthetic portfolio manager’s problem easy to spot.
conditions, the FOMC made an ad hoc cut of 75 basis points (bps) in
The objective is to commit cash and receive the performance of the Index
its fed funds rate target, followed by another reduction of 50 bps at its
via S&P 500 Index futures. Implicit in this synthetic structure is a notional
ensuing regularly scheduled meeting. Tracking errors due to interest
position in an overnight index swap (OIS) that pays fixed interest for the
rate movements were severe, as evidenced by Exhibit 1, which compares
interval until futures expiry and receives floating interest. Regardless
performance of an S&P 500 cash portfolio and a synthetic portfolio built
of whether this notional OIS produces a favorable outcome, it is an
with S&P 500 Index futures over the course of the month.
unintended feature of the synthetic portfolio’s structure, and therefore an
unintended source of risk. The challenge is to find the means to control it.
 Improving Equity Index Futures Tracking and Performance with Interest Rate Futures

Part II: Fed Funds Futures as an OIS Surrogate EXHIBIT 2:

CME Group Fed Funds futures2 have a monthly listing/expiry cycle. Each Using FF futures to lay off risk for the embedded OIS.
contract references the calendar-month average of the effective overnight
Dec 31 07 Jan 31 08
federal funds rate during the contract’s named expiry month. The pricing
FF Futures Price
convention is 100-minus-rate, where “rate” is the average fed funds rate
… Jan 08 95.840 96.065
during the contract expiry month. Thus, an unexpected decrease in the fed
… Feb 08 95.980 97.045
funds rate for the contract expiry month takes the form of an increase in
… Mar 08 96.065 97.245
the futures contract price, and vice versa. Each contract has a notional value
Implied Rate 4.063 2.878
of approximately $5 million. Accordingly, each one bp move in the contract
Finance Rate 4.648 3.174
reference rate is worth $41.67 ( ≈ $5,000,000 x 0.0001 x 30/360). Rate Spread 58.5 29.6

Strips of FF futures are ideally suited for controlling the fixed-rate component
of the notional OIS embedded in the synthetic equity index portfolio.
Continuing with the previous example, consider a $50 million notional-value
position in Mar 08 S&P 500 Index futures on December 31, 2007. These
contracts expired on March 20, 2008. To lay off the notional fixed-rate
financing exposure embedded in the synthetic portfolio, one could have
purchased a properly sized strip of Jan 08, Feb 08 and Mar 08 FF futures:
FF Contract Number
Expiry Months of Contracts
Jan 08 10
Feb 08 10
Mar 08 7
• The FF futures position would have earned $88,166.67. This is
approximately 17.6 bps per annum on $50 million notional value,
enough to narrow the overall total return shortfall (Exhibit 1,
right-hand column) to within 10 bps.
• The 147 bps drop in the overnight financing rate accounted directly
for around 20 bps of the total 27 bps tracking error between the cash
portfolio and the synthetic futures structure. If we use this as the basis
of comparison (instead of the full 27 bps differential between cash
total return and futures total return), then the 17.6 bps gain on the FF
futures hedge would have reduced the pertinent portion of the tracking
error to just 2.4 bps.

• Basis risk explains much of the 2.4 bps residual. In late December 2007,
Note that the Mar 08 component of the strip must be scaled down so that
the basis point value of the hedge matches the interest rate sensitivity of the
fixed-rate leg of the notional OIS3.
Exhibit 2 shows FF futures month-end settlement prices for Dec 07 and
Jan 08. Not surprisingly, FF futures prices rose sharply over this interval.
When applied to the FF futures strip specified earlier, these price gains
would have offset much of the interest-rate related erosion in the S&P 500
cash-futures spread shown in Exhibit 1.
FF futures implied an average overnight rate around 4.063 percent
for the period ending with the equity index futures expiry. At the same
time, the implied term financing rate for S&P 500 Index futures was
4.648 percent, 58.5 bps higher. By the end of January 2008, the spread
between these two rates had narrowed to 29.6 bps. In other words,
the spread between the hedge (the FF contract rate) and the hedge
object (the implied financing rate) shifted by 29 bps over the course
of the month.
cmegroup.com
This hedging strategy is static.4 At the end of the month, the Jan 08
FF contracts expire5, leaving the outstanding Feb 08 and Mar 08
contracts in place. Within the month of January, a Jan 08 FF contract
can be viewed as consisting of two parts: One reflecting the month-
to-date path of realized values of the effective fed funds rate, the other
reflecting market expectations for the balance of the month. Because
the FF contract settles to the arithmetic average of overnight rates
over the entire month, the influence of the second “anticipative” part
gradually shrinks. This means that, even if the hedge position had
been initiated during the month of January, the number of Jan 08 FF
contracts would not need to be reduced (unlike the scaling that is
required for the Mar 08 component of the strip).
By way of caveat, it bears repeating that the spread between the FF
futures contract rate and the financing rate implied by the equity index
futures calendar spread can, on occasion, feature enough volatility
to blunt the effectiveness of the FF hedge. With this in mind, the
practitioner should always take account of the extent to which basis risk
could undermine the performance of the FF futures hedge.
Part III: Eurodollar Futures and Calendar Spreads
Rather than focus on reducing tracking error due to unwanted interest
rate exposure, one might instead greet this exposure as a potential source
of extra alpha. For equity portfolio managers who are also close students
of the money market, a potentially fruitful approach is to trade the equity
financing rate implied in the quarterly calendar spread in equity index
futures.
One can view this implied financing rate as the sum of two components:
(i) the corresponding three-month LIBOR, and (ii) the spread between
three-month LIBOR and the implied financing rate. For market participants
who confine themselves to trading only equity index futures calendar
spreads, these two components are inextricably linked. By contrast,
those who are willing to add an ED futures overlay can isolate the spread
component – a distinct advantage insofar as the spread component
frequently emerges as a source of trading opportunities.
The most obvious time to spot such opportunities, and to exploit them,
is during the quarterly roll, when traffic in equity index futures calendar
spreads is naturally quite high. For example, an investor holding a long
position in Mar S&P 500 Index futures who wants to maintain her long
exposure into the next futures expiry would do so by buying the Mar-Jun
calendar spread (i.e., by selling Mar futures and buying Jun futures). By
taking a position in this futures calendar spread, either long or short, she
The spread component frequently
emerges as a source of trading
opportunities – particularly during
the quarterly roll period.
implicitly takes a view on the rate at which market participants can finance
a notional S&P 500 Equity portfolio for the three-month interval between
futures expiries. To the extent that this is either a low priority or a matter of
indifference to many equity index investment managers, a deft speculator
can profit by taking the other side of the trade.
Exhibit 3 illustrates this point by comparing intra-day movements in
the financing rate implied by calendar spreads in E-mini S&P 500 Index
futures during the Mar-Jun 08 roll against intra-day movements in various
Eurodollar (ED) futures contract rates. Three features warrant mention:
• Throughout the roll period, the short-term interest rate curve was
inverted. Rates implied by Mar 08 ED futures were higher than those
implied by Apr 08 ED futures. (note that Mar 08 ED futures expired on
March 17, 2008)
• Rolling a long position in E-mini S&P 500 Index futures entailed a
simultaneous sale of Mar 08 contracts and purchase of Jun08 contracts.
As noted above, the long futures position implicitly extends the
notional equity portfolio exposure for three months, at an implied
financing rate that spans the term between futures expiry dates. This
interval sits between the three-month periods referenced by Mar 08
and Apr 08 ED contracts. Not surprisingly, the implied financing rate
tends to be bracketed by the Mar 08 and Apr 08 ED contract rates.
• Exhibit 3 reveals considerable movement in the spread between the
implied financing rate and ED contract rates. On volatile days, the
spread’s range approaches 10 bps.
Against this backdrop, consider an example in which you are approaching
a quarterly roll with a 100-contract long position in the nearby E-mini
S&P 500 Index futures. Assume moreover that you intend to roll this
position into the deferred futures. As already noted, the calendar spread
between the expiring contract and the deferred contract incorporates an
assumption that you are paying a fixed financing rate over the three-month
 Improving Equity Index Futures Tracking and Performance with Interest Rate Futures

interval between futures expiry dates. To lay off the LIBOR component of In theory, the order of execution does not matter. For example, nothing
this financing rate (and thereby to isolate the spread), you would buy ED prevents you from opportunistically locking in the ED contract rate first, then
futures. To determine the appropriate scale of the ED futures position, first locking in the equity index financing rate (by buying the equity index futures
compute the dollar value of a 1 bp move in the implied financing rate for calendar spread) later. In practice, however, the futures expiry calendar
100 E-mini S&P 500 futures calendar spreads: constrains your choice of timing. Given that ED futures expire on the Monday
Consectetuer adipiscing elit
prior to the third Wednesday of the month, while S&P 500 Index futures
Notional Value x 0.0001 x 90/360 or, more specifically, expire on the third Friday of the month, the expiring ED futures tend to
100 x $50 x Lead Futures Price x 0.0001 x (90/360) morbi posuere felis eu
cease trading earlier than the expiring equity index futures.8 Thus, if you use
ED futures with the same expiry month as the nearby leg of the equity index
Thus, for example, if the nearby futures price is 1400, each 1 bp move
in the implied financing rate is worth $175.6 Because ED futures7 have a
erat etiam lectus massa iacu-
futures calendar spread, your flexibility in timing would typically be confined
to the first week of the quarterly roll (as Exhibit 3 illustrates).
constant basis point value of $25, the size of the long ED futures position is
7 contracts = $175/$25.
lis in
You can loosen ultrices
this constraint a,EDconvallis
by using an id,
contract with a later expiry
– say, Apr 08 instead of Mar 08 in this example. The cost of doing so,
To make profitable opportunistic use of this combination, you would buy however,tortor. Quisque
may be less liquidity. ED futures withconvallis
standard quarterly expiries
the calendar spread in equity index futures and buy ED futures when (i.e., Mar, Jun, Sep or Dec) tend to trade more deeply than contracts with
the implied financing rate is low relative to the ED futures contract rate.
Conversely, you would unwind the ED futures position whenever the
libero nec arcu.
serial expiries. Given this, you would need to assess (among other things)
whether your ED position is so large as to make these differences in
financing rate implied in your equity index futures calendar spread is high liquidity a material concern.
relative to the ED futures contract rate.

EXHIBIT 3:
The Mar-Jun 08 Roll: Financing rates implied in E-mini S&P 500 Index futures calendar spreads vs. Eurodollar futures contract rates. Note that the
roll period ended one day earlier than is customary, due to the Good Friday market holiday.

2.90

2.80
FOMC
Calendar Spread Implied Rates / Eurodollar Futures

FOMC

2.70

2.60

2.50

2.40

2.30

2.20

Implied
EDH8
2.10
EDJ8
EDK8
2.00
3/10/08 3/11/08 3/12/08 3/13/08 3/14/08 3/17/08 3/18/08 3/19/08
 Part IV: Crossing Over from ED to FF
Recall that the synthetic investment strategy achieves equity market
exposure via equity index futures while earning the overnight interest rate
on investors’ cash. As noted on page one, a crucial feature of the strategy is
that it embeds an implicit overnight equity index swap in which the portfolio
pays a fixed rate, via the term equity financing rate, while receiving a floating
rate. This suggests another approach to picking up incremental alpha, in
which the core equity index futures position is augmented by the FF-ED
spread that lays off both legs of the embedded OIS.
Thus, returning to the earlier Mar-Jun roll example, assume you plan to roll
$50 million notional of S&P 500 Index futures. The companion ED futures
position would be long 50 contracts. Suppose that you incorporate an
appropriately scaled FF futures strip covering the interval between Mar08
and Jun08 Index futures expiries. Its configuration would be as shown on
page six. Importantly, the dollar value of a 1 bp change in money market
interest rates is identical for both legs of the spread. For ED, (50 contracts)
x ($25 per bp per contract) = $,1250. For FF, (30 contracts) x ($41.67 per
bp per contract) = $,1250. Thus, this interest rate futures spread exactly
replicates the spread between overnight fed funds and three-month LIBOR
for the targeted time interval.
FF Contract Number
Expiry Months of Contracts
Mar 089 3
Apr 08 10
May 08 10
Jun 08 7
Recall that we are assuming the notional portfolio positions to be
collateralized fully in money market instruments paying the overnight
interest rate. Thus, we care relatively less about the precise level at which
the FF futures strip is booked.
Far more important is the spread between FF and ED contract rates. The
usual rule of thumb applies: Buy the spread when it is cheap. Exhibit 4
shows the FF-ED spread for the first two weeks in March 2008. With
interest rates as volatile as they have been in recent months, this spread
is capable of swinging 15 bps during the roll – enough to make ample
opportunity for alpha pick-up.
Here too, the sequence by which one legs into this spread does not matter.
You might sell the equity index futures calendar spread first, then sell the
FF-ED spread, or vice versa. The objective is to stitch the trade together as
cheaply as possible.

EXHIBIT 4:
Intra-day graph of the spread between the FF futures strip and Mar 08 ED futures.

76

74

72
Fed Fund/Eurodollar Spread (bps)

70

68

66

64

62

60

58

56

54
3/3/08 3/4/08 3/5/08 3/6/08 3/7/08 3/10/08 3/11/08 3/12/08 3/13/08 3/14/08
Part V: Execution Costs In nearly all environments, judicious
Aside from the extra commission charges, the equity investor considering
these interest rate overlays should take account of slippage costs. application of interest rate futures
Fortunately, the interest rate futures involved in these strategies are very
liquid. During the equity index futures roll month, the applicable ED should improve tracking and
futures typically features a bid/ask spread of ∑ bp. Given that the same ED
futures would be bought and sold in two separate trades, the cost of entry
performance of equity index futures.
and exit would be the entire bid/ask spread of ∑ bp. FF futures trade in
increments of ∂ bp. Since these positions are put on and held until expiry,
however it would be half the bid/ask spread, or ∑ bp. The combined cost for Conclusion
both legs of the spread would be ∂ bp, plus brokerage. The interest rate risks identified above are embedded in equity index
futures and in equity index futures calendar spreads, regardless of whether
To put this in perspective, the typical bid/ask spread in the S&P 500 Index market participants choose to address them explicitly. The tools presented
futures calendar spread is 0.05 index points, equivalent to 1.43 bps10, here enable the practitioner to disassemble the interest rate risk into its
making entry costs for a buy and hold equal to approximately ∆ bp. That various components and then to address each individually.
is, the slippage cost for the interest rate overlay would be less than the
half spread that one would spend in entry cost on the equity index futures Let’s grant that the foregoing examples are drawn from a period of
calendar spread itself. Given the potential for alpha pick-up, this might be extraordinary volatility in both money market interest rates and in the
money well spent. spread relationships among them. Nevertheless, the basic motivation and
structure of the strategies presented here remain valid in calmer waters. In
Alternatively, the trade could be structured in simpler form, by spreading nearly all seasons, judicious application should improve the tracking and
the equity index futures calendar spread directly against the weighted performance of standard equity index futures strategies.
FF futures strip. This would save ∑ bp in bid/ask spread costs plus the
commission on the ED futures leg. The expiration schedule of the ED
futures would no longer enter as a source of interference. The downside
would be the merging of the two rate spread opportunities.

For more information about CME Group Equity products

visit www.cmegroup.com/equities.
Written by Richard Co, Research & Product Development, CME Group. You can contact the author at richard.co@cmegroup.com or 312-930-3227.
1 For the cash index, the total return calculation assumes that the ex-dividend amount is added at the end of the month. For futures, total return assumes the full notional value is invested at the
effective overnight federal funds rate throughout the month.
2 For a complete description of the terms and conditions of 30-Day Federal Funds futures, please visit www.cmegroup.com.
3 Because of the S&P 500 Index futures in this example expire on March 20, 2008, a 1 bp move in the average interest rate level in March would exert impact for only 20/31 of the month. Thus, one
should scale back the number of Mar 08 FF futures to two-thirds of portfolio notional value – in this case 7 contracts instead of 10. Note that this step hinges on the correlation amongst the rates
throughout the month.
4 Certainly, if gains or losses on the stock index were so large as to change significantly the notional value of the position, then the size of the FF futures hedge position might require adjustment.
5 More precisely, the contract is marked to the final settlement price on the first business day of the next calendar month, due to the timing of the publication of effective overnight fed funds rate data.
6 To keep things simple, we assume 90 days between index futures expiry dates. For a large position, an actual day count would usefully improve the precision of the calculation.
7 For a complete description of terms and conditions for Eurodollar futures, please visit www.cmegroup.com.
8 For equity index futures and ED futures that expire in the same month, a little calendar arithmetic reveals that Index futures expire earlier in approximately 28 out of every 100 cases.
9 As before, the odd amounts in the Mar 08 and Jun 08 contracts reflect the portions of those months covered by the time span between Mar 08 and Jun 08 equity index futures expiries: Roughly the
last third of March and the first two thirds of June.
10 Recall that the basis point value of an E-mini S&P 500 calendar spread is $1.75 = $50 x Lead Futures Price x 0.0001 x 90/360, where the lead futures are priced at 1400. The tick increment in the
spread is 0.05 index point, or $50 x 0.05 = $2.50. Assuming a one-tick market, the bid/ask spread is equivalent to $2.50/$1.75 = 1.43 basis points, expressed in implied finance rate terms.
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